Investing, should be simple. You find a company that you like, and buy its stock. You hope that the business grows, and investors will pay a higher price for the stock in the future, as a result. You sell the stock, when you made thousands of percent returns, and retire on a small Caribbean island, with your 21-year-old wife, who can’t stop hanging around the pool boys.
Investing, can’t get much simpler than that… But investors like to be complicated.
Famous “value Investors,” a la Warren Buffet and Ben Graham, weren’t satisfied with the simplicity of investing. They were intellectuals, and determined that returns should be based on breaking down financial statements and figuring out “future cash flows.”
Tangible book value, enterprise value/EBITDA, discounted cash-flow models (DCF), and the dreaded Price-to-Earnings (P/E) ratio, all shun millions of simple-minded folk that prefer to pick stocks that go “up.”
Alas, at the end of the day, these metrics are now standard in the financial industry, and their knowing-of is imperative for the average investor to get a leg up.
But one of the most fundamental (and simple) metrics, the Price-to-Earnings (P/E) multiple, gets a bad rep these days, and i would like to discuss the nature of this ratio, and its current importance, regardless of stock market environment.
The P/E Multiple
The process of valuing a company’s stock, regardless of which method or multiple you use, will ultimately give you the same result; figure out how much earnings a company will return to you over the time of your investment, and whether the stock is selling for below, or above, that number.
As an example, lets pretend you are an entrepreneur, buying a grocery store;
Suppose the current grocery store owner is willing to sell you the whole business for only $1 million. The grocery store produced $100 thousand in earnings for the year 2020. Is this a good deal?
Consider that you had to borrow $1 million from a bank to finance the deal, and the store is expected to produce the same number of earnings for the foreseeable future, it would take you 10 years to pay back the loan before all the following profits from the grocery store would be yours.
Now, let’s change it up; consider the same grocery store owner would’ve offered you the business for $2 million instead. It would now take you 20 years to pay off your loan, before the grocery store’s earnings would be all yours.
That is, essentially, how the P/E multiple works.
In the first example, the grocery store would have a P/E multiple of 10 ($1,000,000/$100,00), where as, in the second example the P/E of the store is 20 ($2,000,000/$100,000).
Using a real-life example, Apple’s (NASDAQ: APPL) business, in its entirety, is worth $2.9 Trillion (good luck getting a bank loan to buy that). Their earnings for the last twelve months were $94.7 billion. Apple, currently, has a P/E multiple north of 30.
That means, if you were trying to buy the whole company, and it made $94.7 billion in profit, every year until eternity, it would take you nearly 30 years to pay off the loans, before any of the company’s profits would enter your wallet. (Basically a mortgage for a house).
Is this is a good deal? Depends on the investor. For a person, nearing retirement, buying Apple may not be the best investment. Who knows if Apple will even be the same company in 30 years? Heck, they might not even be around in 30 years.
But that’s the thing about the P/E multiple. It’s up to the investor to determine the rules.
The difference between say a grocery store, and Apple, is growth potential. A typical grocery store is expected to produce the same amount of earnings forever, until they begin to decline.
Apple, on the other hand, is not.
The company grows their earnings every year, meaning, it might take less than 30 years to get a full return on your investment. That’s why investors are willing to pay a higher price for companies such as Apple.
Then, there are companies such as Capital One (NYSE: COF) or Whirlpool Corporation (NYSE: WHR), that are selling for less than 10x their earnings. Why? Because they aren’t expected to grow at the same rate as Apple.
Does this mean they are worse investments? Not necessarily. It means, they are cheaper.
Lets go back to the grocery store example; suppose you have a choice to put $1 million in a grocery store or $1 million dollars in a hi-tech company. The grocery store will return you $1 million over 10 years, but the high-tech company will return you $1 billion over 30. You might receive more cash from the grocery store in the short-term, but in the long run, the tech company will return more cash and potentially, be valued higher, than the grocery store.
So, does this mean you should buy companies with higher P/E multiples? Not so fast, partner.
Take a company like Tesla (NASDAQ: TSLA). The whole business is worth north of $1 Trillion, with its most recent earnings being $3.5 billion. That gives the business a P/E over 300. Holy Moly.
Tesla, like Apple, isn’t expected to produce the same earnings forever. In fact, they are expected to accelerate their earnings growth for years to come. If the company continues to grow their earnings, by even 50% for the next 10 years, you would currently be paying 5x times their 2030 earnings.
That is, however, if the company preforms to those expectations.
Over-paying for high growth can be a risky game. Amazon (NASDAQ: AMZN) barely ever had a P/E multiple under 100, until recently. If you bought the stock in 2012, when its P/E was 130, you would still have made nearly a 7000% return. And its P/E is still over 60. For the opposite example, see Micron (NASDAQ: MU) in 2000. Some investors are only now breaking even… big sheesh.
With companies like Tesla, or Shopify (NASDAQ: SHOP) it all depends on whether these businesses can maintain their current growth trajectories. If not, look out below.
For the newer investors, the Price-to-Earnings (P/E) multiple, is an artifact from an older generation. It represents a time where institutional investors would buy shares in a company, simply because they were trading at a low P/E. But what about companies that yield no earnings?
Some of the newer, and more well-known, companies such as Uber (NYSE: UBER), AirBNB (NASDAQ: ABNB) and DoorDash (NASDAQ: DASH) are all trading above $50 billion, with not a dollar of earnings to their name. How do you figure out a multiple for them?
Here’s an example:
Lets say you see an opportunity to buy a start-up that manufactures flying cars. The owner gives you a price tag of $150 billion for the whole business.
The problem is, they haven’t sold, and aren’t expected to actually sell, any flying cars for several years.. So… how much is this business REALLY worth?
With these types of businesses, investors are paying for the potential profits that the company MAY produce at some time in the future. Unless you are an analyst in a specific industry, that understands how these companies will turn out, it maybe a bit difficult to pull predictions out of the sky. Therefore, many value investors will stay away from these businesses, until they start producing some sort of earnings.
Some investors, may choose to look at alternative forms of earnings to determine value. Metrics, such as EBITDA (earnings before taxes, interest expenses, and depreciation and amortization) or EBIT (also known as operating income) are considered more appropriate for non-earning businesses. Some investors may even look at the company’s price, relative to their revenue. No matter how you divide it, its all the same thing.
The Price-to-Earnings multiple is still a useful tool for determining whether a business is expensive, or cheap, relative to its expected earnings. If you look at stocks as owning a whole business, the concept of the P/E becomes clearer. Use it wisely, and try not to ignore it. But don’t base your whole investment thesis on it.
After all, some stocks are cheap for a reason, and some stocks are expensive for no reason, other than hype.