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# P/E discussion

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.