Price-to-earnings ratio debunked

As I previously mentioned, there are 2 general types of analysis when you are evaluating a stock. The fundamentals and the technical aspect of market analysis. Remember a stock is a company made up of individuals or a group of individuals trying to achieve a goal.

When I first learned about the stock market, I was perplexed by a single value. In fact it took me a long time to figure out what it is and what it really meant. It is the mystical Price-to-earnings ratio or the P/E ratio. 

So what is a P/E ratio actually?To first understand it we have to define it. As stated by Martin Pring in his book “Technical Analysis Explained, 5th edition”, price-to-earnings ratio is ratio of the price of a stock to the earnings per share.

In layman’s term, it is the PRICE.. (take note guys its a price), a price you (yes you the investor) are willing to pay per 1 dollar (or whatever country denomination that you may have) of earning.

Lets give some basic examples. If the P/E ratio of a company A is..lets say 10, then you are paying 10 dollars for 1 dollar of company A’s earnings. If you have another company (company B) with the P/E ratio is 5, then you are paying 5 dollars per 1 dollar of earning. Got it?

So lets analyze a bit. If I ask you now, which is more expensive company A that has a P/E ratio of 10 or company B that has a P/E ratio of 5? Obviously you would say company B is cheaper as you are buying the company for 5 dollars per dollar of earning. Correct?

Well, in essence, yes company B is cheaper but take note that this is just one of the many many metrics to measure a company and should not be used solely alone when you want to buy a stock.

So you might be thinking why would some investors would opt to buy the more expensive stock than the cheaper one? The answer to this is the current state of the company.

Lets say, that you have a new company and its growing really really fast. It provides good product and services and its getting popular through good marketing. This would obviously attract investors towards this new popular company. Of course through the popularity and good marketing of the company, more and more investors opt to buy this company. Therefore, if more investors are buying this company then there is more demand for this particular stock. If there is more demand for this stock, then the price would go up.

If the price go up due to high demand more than its earnings, what would happen?

I made table here to show you how a fast growing popular company influences the P/E ratio.Lets assume that we bought stocks of a company with fast growth potential in year 1 with a starting P/E ratio of 5.

As you can see here, if you bought a stock in year 1 for 5 dollars, you already made a position early on for 5 dollars. If the company continues its high growth for the next 4 years and assuming the company grew in size and the price went up from 5 dollars to 20 dollars, your investment now grew four fold or 400%!! Thats huge. 

In the real world, the earnings of a company increases as it grows or else the price-to-earnings ratio would now be too high or too expensive for most investors to buy. 

In the next scenario, we would take a look at a company with growing stock price moving faster than its earnings. 

The price-to-earnings ratio still increases through time relative to its earnings, however, the rise in earnings partially offsets its increase. However, if you place your investment at year 1, you would still get four fold increase in your position in year 4. 

So, how high a P/E ratio are you willing to hold your investment? It now depends on you and what the outlook for the company looks like in the future. Therefore, the P/E ratio is just a tool and not a sole index to make your investment decisions in the future. 

This is now the basic explanation as to why some investors opt to buy a stock with increasing P/E ratio and the main reason for such is that the company is very attractive, it has good leadership and good marketing skills.

So if you are one of the investors buying this type of company, then you must be a growth investors.

Growth investors are individuals who search, research and invest in companies that have a high growth rate. If I can give you some companies that have a very high growth rate in the past and present, they are Microsoft, Apple and Tesla just to name a few. During their inception, these companies have phenomenal growth rates that growth investors love to buy. They buy the shares of these companies as prices really go up very fast and reap their profit in the long run. 

On the contrary, companies have a peak depending on their product, innovation and leadership strategies and in the long run, their growth declines. Now, in order to stay relevant, the previous growth companies that have already matured will now focus on EARNINGS or profit. They will try to boost the sales, innovate new products, increase the profit margin, outsource their productions elsewhere more affordable and probably streamline their workforce in order to maximize profit.
Hence, if they continue to increase their earnings relative to their stock price, it will result to a drop in their P/E ratio. 

Now if you are an investor looking for companies that are “cheap” (lower P/E ratio), then you must be a value investor.

Value investors generally look for companies with high earnings and dividend yields. They focus more on a ratio called Price/Book ratio which I’ll discuss in the future topics but for the meantime we will discuss how a good company with a low P/E ratio can reap rewards.

So now, you might be thinking how would you, the investor, earn from a low P/E ratio in a company that is not growing much? Here’s one good example.

Suppose that you own a good company that has a low P/E ratio. This company has good fundamental value based on your analysis. Lets put the P/E ratio to 3. Due to the company’s massive earnings, it was able to put provide another product or another subcompany under its umbrella. 

Since, the P/E ratio of 3 is lowered by massive earnings, you now as a value investor have placed your position on a low price. Now, if this company attracts many value investors like you then demand rises pushing the price up.

The table above is an example of investing in a local beverage company as a value investor. Again, this is a scenario where you have done your research with the company’s leadership, business experience and their mission and vision going forwards. 

On year 1 ,it has a P/E ratio of 3 which is very cheap. Suppose that this beverage company has future plans of expanding globally in the next 3-4 years and after such time it was successful in establishing its foothold in a global fashion. Being global, this beverage company will be able to reach out to more buyers or consumers than ever before and if they are successful enough, their earnings would shot up sky high. 

Year 3, 4 and 5 may be the time that they are getting recognized and being recognized will attract more investors. The investors now will provide funds for this company to expand and increase their sales translating to higher earnings. 

You, now, as a value investor held up your position in year 1 for 3 dollars and if you are patient enough to hold your investment in this successful beverage company, you would have gained 600 dollars in year 10. Thats 20,000% increase in your investment!! Thats GINORMOUS!

One of the most successful value in our time is none other than Warren Buffet himself who has been dubbed the Oracle of Omaha. He is famous for his quote “The longer the view, the wiser the intention”. 

Either way whether you are a growth or value investor, it is very important to do your research and be updated with the what is going on with the company. 

RESEARCH, RESEARCH and do more market RESEARCH. 

Usually the company registered in the stock market has its financials open for you to do your research. They usually publish quarterly reports and yearly or annual reports at your convenience. The good thing about this is that you, the investor, have the same equal footing as those large financial groups as information can easily be accessed online. Anyway, this is another topic. 

I hope I am able to enlighten you in demystifying the once very puzzling price-to-earnings ratio.