Monday, April 13, 2009

An Intuitive Understanding of P-E Ratios

One of the most common measures used to describe equity valuations is the Price-to-Earnings ratio. I have used it myself quite a lot on this blog and I think it gets thrown around so often that some people who may not fully grasp what it means or why its important may be hesitant to ask about it. I suppose it is also possible that the concept is so simple that it needs no further explication by me or anyone else. Still, I think it deserves some time.

The reason for that is that the price to earnings ratio is kind of an abstraction. What does it mean to have a stock be five times or three times or twenty times the annual earnings? People don’t really think about the number that much beyond thinking that a stock with a low price to earnings ratio is cheap and one with a high price to earnings ratio is expensive. Generally people can compare PE ratios to one another but don’t really think about what they intrinsically mean.

I think it’s easiest to think about a lot of things in the financial world in terms of an ordinary business and my favourite kind of business is a diner. So imagine that you and I are partners in a diner and we would like to retire to Florida. In order to do this we have to sell our diner. How would we decide what a fair price for it was? We would probably think about how much money we had invested in it over time. Maybe about how much it would cost someone to start from scratch like we did. Mostly we would have to think about what would be in the mind of the buyer.

What would be in the mind of the buyer would be how much money he would make if he bought it. Let’s say our diner makes $100,000 per year. Should we sell it for that? Probably not because all we would have to do is put off retirement for a year in order to get that. Additionally a single years earnings is probably far less than it would cost him to set up from scratch. It might be more reasonable for us to sell for several years worth of earnings. Let’s say we charge him years of earnings or $700,000 just to pick a number out of the air. This means that he would be buying our business for an effective price to earnings ratio of 7. You can think of PE as the number of years of earnings you would have to pay someone to take over their business.

What are the things that determine the number of years of earnings you would have to pay in order to buy a business? Well, probably the most important would be the rate of growth of those earnings. Let’s say for example that we knew that a factory was going to be built next to our diner. So we know that we can serve flapjacks and coffee up to hungry construction workers next year and the year after that we can serve them up to even more factory workers.
So let’s say this coming year we’ll make $100,000, the year after that $200,000 and the year after that 400,000. Are we still going to sell for $700,000 or a 7 PE? Probably not because we just have to stick around for three years to get that much. We’d probably hold out for more and our prospective buyer would probably be willing to pay more.

Another factor is how easy it is to borrow money generally. How much our buyer is willing to pay us is going to have a lot to do with how much of the money he has to put up himself. Let’s say our buyer can borrow $500,000 and agrees to pay us $700,000. So he has to put up $200,000 of his own money and if he’s making $100,000 a year that’s a 50% return on his investment. Not a bad deal. But if he has to put up all the money then he makes only $100,000 on his $700,000 investment, or 14% or so. He might be willing to pay a lot less if he has to put up all the money himself. Along the same lines the level of interest rates is an issue. If the bank is willing to lend him the money but is going to charge him a high rate of interest he’s going to be able to keep less of the $100,000 for himself, that lowers his returns and also increases his risk a little because the bank gets paid first and if he can’t pay them then they get the whole thing in default.

So some of the reasons why the stock market has been so volatile lately is that people are very uncertain both about the level of earnings and what the appropriate PE ratio is. As you can see, saying that there is a mystery about the PE ratio is really the same thing as saying that there is uncertainty about the rate of growth in the economy, the availability of credit, and the level of interest rates. This is what accounts for the very high levels of volatility in the markets these days.

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