Commentary

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The Price Earnings Ratio

Posted on 5/7/2018 by
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The legendary Warren Buffet is famous for investing excellence and memorable sayings, among other things. One maxim of his that is particularly memorable to us is ”Price is what you pay. Value is what you get.” Over the past few months the topic of price has been mentioned often when reviewing buy or sell candidates.

The legendary Warren Buffet is famous for investing excellence and memorable sayings, among other things. One maxim of his that is particularly memorable to us is ”Price is what you pay. Value is what you get.” Over the past few months the topic of price has been mentioned often when reviewing buy or sell candidates. The comments might be ‘that stock is $250, isn’t that expensive?’ Or ‘that stock was $45 and now it’s $150, isn’t that too high?’ Well, Mr. Buffet’s saying holds the answer. In order to begin to get a feel about the price of the stock we have to get a handle on what value we get for the price we pay.Investors have long considered the price earnings ratio (P/E) a useful metric for evaluating the relative attractiveness of a company’s stock price compared to the current earnings of the firm. The P/E is often thought of as a first measure to attempt to ‘value’ a company. When we invest in a stock we have an owner’s claim on its earnings per share. Since the P/E is calculated by dividing the price of the stock by its current or expected earnings, P/E shows us at a glance how many dollars the market requires to own one dollar of earnings. Below we will take a look at three scenarios where price alone may not be helpful in assessing the potential of an investment; in one the price has increased dramatically from one period to the next and the earnings kept pace; in the next, the price has decreased just as dramatically and, alas, so have the earnings; and, in the finalscenario, the price rose while its earnings did not.

Scenario One - Google: At the end of 2012, Google was expected to produce about $19 in earnings and its price was $355 for a P/E of 18.7 (355/19). Today, the price of Google, now Alphabet (tomorrow American Pharaoh??), is expected to earn about $42 a share and its price at this writing is $1,019 for a P/E of 24.4.

Is 24.4 too high? It depends. The price we have to pay for a dollar of Google’s earnings has gone from 18 to 24, an increase of 33%, while its earnings have gone up 2 ½ times and its price has appreciated almost three-fold! As Adam Sandler might say, “Not too shabby”. With perfect hindsight, it was a bargain in 2012 and it may be today, if Google continues to deliver. We are certain that $1,000 is not necessarily ”expensive” when that $1,000 comes with $42 of earnings that are growing like weeds with no apparent weed killer on the horizon.

Scenario Two, General Electric (GE): In 2001, GE was featured in the classic business book “Good to Great” by Jim Collins as an excellent example of an excellent company. It is easy to imagine that a lower price for GE would be a strong signal that it could be an attractive stock. Today, we have a lower price and GE might not be an appealing investment.

Let’s go back again to 2012. A share of GE then cost $21 and it brought with it expected earnings of $1.50, a P/E of 14. Between 2012 and now GE has been through some challenging days, recognizing that its once dominant Financial Services Division needed to be unwound and the unwinding has come at a substantial cost. Today, GE’s price is lower than it was in 2012 but its expected earnings are lower still. Although at $14 GE’s price is 33% lower than its level in 2012, its expected earnings are $1.00, also 33% lower. GE had a P/E of 14 six years ago and a P/E of 14 now. To be fair, neither the price of GE nor its P/E were particularly helpful as a guide to investment attractiveness then and now, which is often the case with a company at a crossroads. GE had a power outage a year ago and technicians are still attempting to find and fix the causes. With GE we know the price today but the value we could expect is much less clear.

Scenario Three, Walmart: Our third example, Walmart, features a company that has been dealing with new competitive realities on many fronts the last several years and has been attempting to re-establish the dominance it had enjoyed for decades before. Walmart’s endeavors at transition have not been uniformly successful and the company’s earnings have been weak. In 2012 Walmart earned $5.02 a share and is expected to earn $4.95 in 2018. It’s price has moved from about $62 in 2012 to $87 at this writing. With unchanged earnings you probably now know that its P/E must be higher today than 6 years ago, and it is. In fact Walmart’s P/E expanded from 12.3 (62/5.02) to 17.5 (87/4.95).

Does the higher price and the higher P/E mean that Walmart is an expensive stock? Maybe.

Several factors affect the P/E, and two important ones are the estimated growth rate of earnings and the degree of uncertainty surrounding the estimate. All else equal, the higher the expected growth and the lower the uncertainty, the higher the P/E; the lower the growth estimate and the higher the uncertainty, the lower the P/E. Walmart has a very high degree of uncertainty so, with a higher P/E than before, investors must have higher expectations than before. In Walmart’s case we must understand investor expectations to begin to make a judgment about its investment allure.

Summary: P/E ratios are a great first cut at what investors see as the ‘value’ they might receive for the ‘price’ they have to pay in Mr. Buffet’s saying, but they have limitations. Because of that, investors include other ratios or metrics to round out their review of the value we might receive for the price we pay. We have begun to describe our investment process whereby we consider multiple pieces of information for every investment candidate. P/E is an important metric in the ‘valuation’ block but there are several more. In addition to the ‘valuations’ exercise, we want to know the quality and reliability of the earnings the company reports, the degree to which management might be a good steward of our capital, and more. Over time, we will describe many key variables that help us choose a stock for the HedgeHog portfolio. The price of the stock today, all by itself, is not particulary useful as we consider whether to invest. The price six years ago is not all that useful either, all by itself. We need to compare some metrics of ‘value’ that we could receive for the price we have to pay to begin to know how attractive a potential investment might be. The P/E Ratio, since it equates today’s price with today’s earnings, is a good start toward our goal. To answer the questions at the top of this note regarding the price of the stock and whether it is ‘expensive’, it seems like a good idea to turn toward the P/E ratio for our initial guidance, not the price alone.

 

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