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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 the same industry 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 about in the future about why that is we'll get more into the nuance but let's just say they're in the same industry maybe they're software companies maybe I can buy Company A each share I can buy it for us so the price per share 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 and we learned that in our first video let's say that it's 2008 earnings 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 price to earnings company a 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 looked 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 using historical earnings are using the past 12-month 12-month earnings are 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 more in this video but so based on 2008 earnings the price to 2008 earnings for company a is 10 price to 2008 earnings for Company B is 4 so for every 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 this looks cheaper right low to 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 the risk in terms of the markets they operate in in terms of who are their customers and and how much of a competitive and advantage they have if all of those things were completely completely identical you would be correct you would be correct that this would that Company B was cheaper and notice that it's 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 in the real market where you see two identical companies and one or you think they're identical companies and one is trading at a lower multiple or lower price to earnings multiple than the other you should be very suspicious there's some chance that just you're the first person to notice this discrepancy and then in that case you should go in and buy Company B and if you're into shorting things you could short company and you could make a lot of money but you should be very suspicious it's kind of like the classical you know two economists walking down the street and they see a they see a $20 bill they see a $20 bill and one economist said hey well you know why don't I pick up the $20 bill and it 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 really 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 and maybe people with 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 their 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 still be pit willing why would someone be willing to pay a price to earnings ratio of 10 for company a and and and pass up or maybe not want to buy Company B even though they're paying only a price to earnings ratio for why would they rather pay 10 dollars for every one dollar of earnings in 2008 as opposed to four dollars of every earnings in 2008 every dollar of earnings and we touched on it in the last video maybe they think company a is a lot safer it's closer to a you know like a bank account that you know Company B sure it made $5 in earnings but that is risky you don't know every year you know maybe one year makes five dollars maybe the next year it loses five dollars while company is is more steady so that's one reason and the other reason is this was just 2008 earnings but just one year earnings really don't capture what's happening at a company 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 and it 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 let's we said this is 2008 earnings but let's say that 2009 earnings the picture looks a little bit different we draw this year so let's say 2009 in 2009 2009 EPS so this is a and this is B a is expected to make a is expected to make two dollars per share and B is also expected to make I don't know let's say B continues to make let's say B is going to make four dollars per share so now if you took the price to earnings ratio on 2009 earnings some of which is behind us so I'm making this video in August of 2009 so we know half the year but the other part of this number is kind of a projection we get hopefully diligent and intelligent people have come out with this estimate so as often times you'll see this is a 2009 estimate EPS this is the people's best guess but here the price the price to earnings for 2009 then becomes a see if I'm paying $10 today for $2 versions in 2009 it's a price to earnings of five for a company a well for Company B it's a priced 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 look back at 2008 earnings company a looked expensive higher price to earnings and Company B but then when you look at the current earnings they look they look similar now why the question was why would someone want to pay more for company a well or you know why would they choose company over this this analysis I just said said o based on 2009 they look it looks neutral their price to earnings ratio are the same for every dollar in earnings you're paying $5 but notice a trend in 2008 they made a dollar then they made 2 dollars in 2009 and maybe there are some estimates for 2010 maybe in 2000 or maybe you can make your own estimate so maybe in 2010 people saying this company company a has a great product it's growing the markets growing maybe in 2010 company a is going to make 2 dollars and 50 Cent's it's going to grow another 25% in in 2010 maybe this growth rate slows a little but it's going to continue to grow while company B it went from $5 of earnings in 2008 to $4 in 2009 and maybe maybe it shrinks a little bit maybe it's shrinks in half maybe but it goes to $2 in 2010 so now if you do a price to earnings on 2010 on 2010 earnings so this is you know 18 months out from when this video is being made eat all of a sudden your price-to-earnings your priced earnings of relative to 2010 earnings is four for Company A and it's ten for Company B so now we've 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 is that in the 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 good exercise when you let's say you see a company sometimes someone might look at a company and let's say there is you know let's say Company C it's trading at $100 it's trading at $100 and let's say for 2009 people expect it's going to make 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 2009 they'll say this is a hundred price to earnings ratio that's crazy I would never pay that's an expensive company maybe they'll even short it there which is it can be a very foolhardy thing to do if you're not careful but the what you might say no no no don't short it just yet think about this company is growing so fast based on my projections they've just really tapped into this market they have this intellectual property known can compete with them in 2010 that I I expect this company to double every year let's say I expect them to grow a hundred percent every year for the next three years and the other purse is Oh fine okay in 2010 if they're going to double they're going to make two dollars well that's still a price to earnings based on 2010 2010 of C one hundred divided by two is 50 you like that still expensive that's still way more expensive than most companies the average price to earnings ratio in the market right now I believe 17 or 18 why would I pay 50 times 2010 earnings I'm really going in the forward and we all know if you've watched the present value videos that money in the future earnings in the future are worth less than earning today but you say no but you know these guys are growing so fast in 2011 2011 they're going to make $4 and then all of a sudden the price to earnings ratio 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 just going to keep doubling all the way into 2012 and now all of a sudden you're trading at 12 and a half times 2012 earnings and then if that growth were to continue and this is an important point the growth has to continue that growth can't you can't just say Oh something throwing a hundred percent for one year I'm willing to pay a hundred times that because if it grows one hundred percent for one year and then stops growing there's no way that you would want to pay fifty times earnings for something that's not growing in the future but if it keeps going at a hundred percent per year for five years then it actually might seem interesting so in 2013 I'll be making sixteen dollars and then we're looking at a six and you know six and change price to earnings which is downright cheap so the debate on whether you're willing to pay you know when you look at a price to earnings ratio of a hundred a lot of people will have a knee-jerk reaction saying 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 let's say in this case 100 percent a year in order to justify this they have 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 percent a year for five or six years this is actually a good deal if it's growing 100 percent a year for 20 years this is actually a very good deal obviously a six 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 it was worth as much as earnings today and you could watch the present value video but give or take 100 percent 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 were why you're 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 but a lot of people you know 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 you're with that you know of kind of a fair or cheap price to earnings is ten times you know ten times this year or last year ten times earnings and you might wonder where does that come from why isn't it not nine times earnings or twelve times earnings and that's actually a very good question there's actually no obvious reason why it isn't nine or eleven or twelve it's just ten because one this is a nice round number and also if you were to take an earning stream so if you were to take you know if a company in 2009 2010 2011 2012 it just kept going and if it had an earning stream let's say in every year it's going to make $1 and 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 lets say they make $1 for ever 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 you know roughly 10 or 11% this is all a little bit of hand wavy so this the value of that dollar would be 1 divided by 1.1 1 I just added the 11% here the value of that dollar would be 1 divided by 1.1 1 squared this dollar would be 1 point 1 1 to the 3rd if you were to add up the present value of that income stream you're going to get roughly 10 10 dollars or 10 times the earning stream so that's where it comes from it's it's kind of 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 be able to justify a higher price to earnings but I don't want to go there just yet anyway see you the next video