If you're seeing this message, it means we're having trouble loading external resources on our website.

If you're behind a web filter, please make sure that the domains *.kastatic.org and *.kasandbox.org are unblocked.

Main content

Video transcript

We now know how to calculate the Price to Earnings ratio. Let's see if we can use it to make a judgment about whether a company is cheap or expensive relative to another company. So let's say I have Company A and I have Company B. And for the sake of our discussion, let's say they're in the same industry. And that's important because Price to Earnings really is more of a relative valuation. You kind of want to compare apples to apples. It's hard to compare one Price to Earnings in one industry to another. We'll talk a lot in the future about why that is, and we'll get more into the nuance. But let's just say they're in the same industry. Maybe they're software companies. Maybe Company A, each share I can buy it for, so the price per share of Company A is $10. Price per share of Company B is $20. So remember, just this information alone does not tell me that A is cheap and B is expensive. We learned that in our first video. And let's say that it's 2008 earnings. Company A made $1 per share. $1 of EPS. This is Earnings Per Share, not total earnings. To figure out total earnings, we would take this number and multiply by the number of shares. And let's say Company B made $5 per share. $5 EPS, Earnings Per Share. So what are their respective Price to Earnings ratios? Company is 10. The price is $10, the earnings is $1, so $10 divided by $1 is 10. Company B, the price is $20, the earnings are $5. $20 divided by $5 is 4. So just when you look at it superficially right here, when you take Price to Earnings-- and actually just as a little aside, whenever someone says the Price to Earnings ratio is 10, or the Price to Earnings for Company B is 4, the first thing you should ask is, what earnings are you using? Are you using historical earnings? Are you using the past 12 months earnings? Are you using future earnings? In this case, we use last year's earnings. We use 2008 earnings. And that's a key thing. And we'll talk about that if we have time a little bit more in this video. So based on 2008 earnings, the price to 2008 earnings for Company A is 10. The price to 2008 earnings for Company B is 4. So for every dollar of earnings per year, if you believe that the 2008 earnings are indicative, you're paying $4 here. For every dollar of earnings here, you're paying $10. So based on that, this looks cheaper. Low Price to Earnings ratio implies that it's cheaper. For the same earnings you're paying a lower price. For every dollar of earnings, you're paying $4. For every dollar of earnings here, you're paying $10. So it looks like it's cheaper. And if everything was equal, if these companies really were equal, in terms of their capital structure, in terms of how much debt they had, in terms of their growth rate, in terms of their risk, in terms of the markets they operate in, in terms of who are their customers, and how much of a competitive advantage they have. If all of those things were completely identical, you would be correct. You would be correct that Company B was cheaper. And notice that it's the complete opposite of just the superficial price. The price here, Company B was more. But when you look at the Price to Earnings ratio, you say Company B is cheaper. Now, immediately if you were to see this is the real market, where you see two identical companies-- or you think they're identical companies-- and one is trading at a lower multiple or a lower Price to Earnings multiple than the other, you should be very suspicious. There's some chance that you're the first person to notice this discrepancy, and then in that case you should go and buy Company B. And if you're into shorting things, you could short Company A, and you could make a lot of money. But you should be very suspicious. Is kind of like the classical two economists walking down the street. And they see a $20 bill. And one economist says, hey, why don't I pick up the $20 bill. And he says, no you silly, how can you be an economist? It clearly isn't a $20 bill, because if it was, someone else would have picked it up before us. That markets don't allow just free money to be sitting around there. And if these companies were truly identical, this discrepancy would be free money. And the first person to see it would start buying Company B, and the price would move up. And maybe people would short Company A, and the price would move down. And that would happen very quickly in today's public markets. And at some point, these Price to Earnings ratios should be equal if-- and this is a big if-- if these companies really are equal in terms of their earnings potential and the risks and their growth. But let me ask you a question. Let's say that we don't know that they're truly equal. Why would someone be willing to pay a Price to Earnings ratio of 10 for Company A and pass up, or maybe not want to buy, Company B, even though they're paying only a Price to Earnings ratio of 4. Why would they rather pay $10 for every $1 of earnings in 2008, as opposed to $4 of every dollar of earnings in 2008? We touched on it in the last video. Maybe they think Company A is a lot safer. It's closer to a bank account that-- Company B, sure it made $5 in earnings, but that is risky. You don't know. Every year, maybe one year it makes $5, and maybe the next it loses $5. Well Company A is more steady, so that's one reason. And the other reason is, this was just 2008 earnings. But just one year of earnings really don't capture what's happening at a company. A company could do really good one year, really bad the next. It might be shrinking. It might be growing. And this is the important thing. There's always this temptation in investing to always look back. To see what happened to the stock in the past. Or how much did the company earn in the past? Or how much did it grow in the past? But that's all irrelevant. That's already in the stock. That's already happened, whatever money was there to be made has already been made. You always have to be looking forward. So we said this is 2008 earnings. But let's say 2009 earnings, the picture looks a little bit different. Let me draw this here. So let's say in 2009 EPS-- this is A and this is B-- A is expected to make $2 per share. And B is expected to make $4 per share. So now if you took the Price to Earnings ratio on 2009 earnings-- some of which is behind us because I'm making this video in August of 2009-- and so we know half the year. But the other part of this number is kind of a projection. Hopefully diligent and intelligent people have come up with this estimate. So oftentimes you'll see this as a 2009 estimate EPS. This is people's best guess. But here, the Price to Earnings for 2009 then becomes-- let's see. If I'm paying $10 today for $2 of earnings in 2009, the Price to Earnings of 5 for Company A. Well, for Company B, it's a Price to Earnings 20 divided by 4. It's also a 5. So notice. Now when you look at 2009 earnings, they look pretty similar. So although when you looked back at 2008 earnings, Company A looked expensive. Higher Price to Earnings in Company B. But then when you look at the current earnings, they look similar. Now the question was, why would someone want to pay more for Company A? Why would they choose Company A over this? This analysis I just said said, oh, based on 2009 it looks neutral. The Price to Earnings ratio is the same. For every $1 in earnings, you're paying $5. But notice a trend. In 2008, they made $1. Then they made $2 in 2009. And maybe there's some estimates for 2010. Or maybe you can make your own estimate. So maybe in 2010 people are saying Company A has a great product. It's growing. The market's growing. Maybe in 2010, Company A is going to make $2.50. It's going to grow another 25% in 2010. Maybe its growth rate slows a little bit. But it's going to continue to grow. While Company B went from $5 of earnings in 2008 to $4 in 2009, and maybe it shrinks a little bit. Maybe it shrinks in half. Maybe it goes to $2 in 2010. So now if you do a Price to Earnings on 2010 earnings-- so this is 18 months out from when this video is being made-- all of a sudden, your Price to Earnings relative to 2010 earnings is 4 for Company A. And it's 10 for Company B. So now we switched places. Now Company B looks more expensive on 2010 earnings. And Company A looks downright cheap. And this is an important thing to realize. In a present period, you are willing to pay a higher Price to Earnings ratio if the company is growing. And you're going to pay a lower Price to Earnings ratio if the company isn't growing. So growth is the other reason why you're willing to pay a higher Price to Earnings ratio. A good exercise, let's say you see a company. Sometimes someone might look at a company. Company C is trading at $100. And let's say for 2009 people expect it's going to make $1. So a lot of people immediately will figure out the Price to Earnings based on 2009 estimated earnings. Remember, it's always important to know what the E is. This is 2009 estimates. They'll say, this is 100 Price to Earnings Ratio. That's crazy. I would never pay that. That's an expensive company. And maybe they'll even short it there. Which can be a very foolhardy thing to do if you're not careful. But you might say, oh no, don't short it just yet. Think about it. This company's growing so fast, based on my projections they've just really tapped into this market. They have this intellectual property, and no one can compete with them. In 2010 I expect this company to double every year. I expect them to grow 100% every year for the next three years. And the other person says, oh fine. OK. In 2010 if they're going to double, they're going to make $2. Well that's still a Price to Earnings based on 2010 of-- 100 divided by 2 is 50-- you're like, that's still expensive. That's still way more expensive than most companies. The average Price to Earnings ratio in the market right now I believe is 17 or 18. Why would I pay 50 times 2010 earnings? I'm really going forward. We all know if you've watched the present value videos, money in the future, earnings in the future are worth less than earnings today. But you say, no but these guys are growing so fast in 2011 they're going to make $4. Then all of a sudden the Price to Earnings ratio is starting to look a little bit better. 25. And then you could say, not only that, but in 2012 I'm so confident that these guys have tapped into this huge market, they're going to make $8 per share. They're going to keep doubling all the way into 2012. And now all of a sudden, you're trading at 12.5 times. And then if that growth were to continue-- and this is an important point-- the growth has to continue. You can't just say, oh if something's growing at 100% for one year, I'm willing to pay 100 times that. Because if it grows 100% for one year, then stops growing, there's no way that you would want to pay 50 times earnings for something that's not growing in the future. But if it keeps growing at 100% per year for 5 years, then it actually might seem interesting. So in 2013 you'll be making $16. And then we're looking at a 6 and change Price to Earnings, which is downright cheap. So the debate on whether you're willing to pay-- When you look at a Price to Earnings ratio of 100, a lot of people have a knee-jerk reaction. They say, that is unbelievably expensive. The market is crazy. Why on earth would anyone pay $100? And the reason that they're paying $100, if they're not speculators, and obviously most people in the market are, is that they believe that this company is growing very fast-- in this case 100% a year. And in order to justify this, the company has to grow that fast for many, many, many years. So in this case maybe at least five or six years. Then all of a sudden this doesn't seem that crazy. For a company that's growing 100% a year for five or six years, this is actually a good deal. If it's growing 100% a year for 20 years, this is actually a very good deal. Obviously a 6 Price to Earnings of 20 times 2013 earnings isn't as good as a 6 Price to Earnings of 2010, because earnings in the future aren't worth as much as earnings today. And you can watch the present value video. But give or take, 100% growth is much larger than what most discount rates would be. So this is a good way to think about it. The reason why you are willing to pay a higher Price to Earnings is for growth, and even more for growth that will continue and that you think has a very high likelihood of occurring. And then the other reason is you think there's very low risk. And we touched on that in the first video when we talked about bank accounts. And why someone's willing to pay a 50 Price to Earnings essentially for a bank account. And one last point-- and I'll just touch on this at the end of the video. It's a little bit of technical. There's kind of a general rule of thumb that if a company is not doing anything, it's just stable, safe, not moving up or down, that a fair or a cheap Price to Earnings is 10 times this year or last year. 10 times earnings. And you might wonder, where does that come from? Why isn't it 9 times earnings or 12 times earnings? And that's actually a very good question. There's actually no obvious reason why it isn't 9 or 11 or 12. It's just 10 because one, this is a nice round number. And also, if you were to take an earnings stream. So if you were to take a company in 2009, 2010, 2011, 2012, and just kept going, and if it had an earnings stream. Let's say in every year it's going to make $1. And if you were to discount this back. And you should watch the present value videos, if this makes no sense to you. But if you were to present value this-- let's say they make $1 forever going into the future-- and you were to present value this using a discount rate. So 2009 money, that's worth $1. 2010 money, you want to discount it. So you want to divide it by, let's say we use 11% as a discount rate. And actually, roughly 10 or 11%. This is all a little bit of hand waving. So the value of that dollar would be 1 divided by 1.11. I've just added the 11% here. The value of that dollar would be 1 divided by 1.11 squared. This dollar would be 1.11 to the third. If you were to add up the present value of that income stream, you're going to get roughly $10 or 10 times the earnings stream. So that's where it comes from. Instead of doing this present value calculation for everything, and there's so much error involved anyway, in terms of just estimating earnings, people just give a rule of thumb. But obviously if interest rates go down, then this number will go down, and you might be able to justify a higher Price to Earnings, but I don't want to go there just yet. Anyway, see you in the next video.