If you are interested in stock investing, you have probably heard this term used before: the price to earnings ratio. Today I’m going to review what this means, simplify the concept a bit and review an example of how you may use this metric to inform an investing decision.
The concept itself seems simple enough – what is the cost of the stock compared to how much the company earns… right? But what does this metric actually mean and when does it make sense to use?
The definition of the price to earnings ratio is the stock price of the company at the time divided by the company’s earnings per share. (Stock price/EPS).
As an investor that researches and selects individual stocks for my portfolio, I prefer simple ways to understand why this ratio is important and an example of how this can be used to inform investment decisions. I’m going to simplify the definition a bit and then show a few examples highlighting how the P/E ratio can be used.
Here is an oversimplified way to explain a price to earnings ratio: The price to earnings ratio signifies how many years would it take the company to earn back your investment if the company’s earnings remained the same forever.
Let’s take the company Verizon just to use an example. As of the end of the year 2020, Verizon’s stock price was $58.75 per share. For the year 2020, the company earned $4.30 per share. If you take the stock price at the time and divide by the earnings per share for that year, you get a price to earnings ratio of 13.66.
If Verizon did literally nothing with their business at all for the foreseeable future and their earnings didn’t change, it would take you 13.66 years for the company to provide you enough earning power to earn back the investment you made in them. ($4.30 in earnings per share per year… it would take Verizon 13.66 years for the company to earn $58.75 for the share price at which you invested into the company).
This is a great way to think of the P/E ratio in a vacuum. If nothing else at all happens with the company’s earnings or amount of shares outstanding, this is how many years it would take for that company create enough value to earn back the investment you made in them.
However, we all know that earnings don’t exist in a vacuum, so I want to provide a few examples that show how simple earnings growth and declines can affect how long it takes a company to earn back your investment in them.
Let’s use the same example we started with, and use our Verizon numbers. Except instead, let’s add a simple 5% earnings per share growth and a 5% earnings per share decline every year to see how that affects the earnings per share over time. See the results below.
As you can see in the example, after a few years earnings growth and earnings declines start to matter. The 10 year difference between the same company that would grow their earnings 5% annually vs. those earnings declining by 5% annually is pretty drastic. Let’s say you bought one share of Verizon in each of these hypothetical scenarios – how many years would it take the company to earn back the money you invested in them?
This example highlights exactly why growth companies like Tesla, Salesforce, Amazon etc. command a much higher price to earnings ratio. Yes, it may be high to pay up in the moment for a price to earnings ratio of 50+ for a growth company, but if the company is continuing to grow their earnings at 20, 30, 40 percent annually then it’s not actually going to take the company 50 years to earn back the value for which you bought their shares. In the example above, with a small 5% annual earnings growth, it took our hypothetical Verizon only 10.5 years to earn back the investment we made in their company.
Conversely, this example also shows the deadly power of earnings declines. If the company’s earnings per share decline at 5% per year, it would actually take the company over 22 years to earn back our initial investment.
Keep in mind the P/E ratio is just one tool that investors can use to evaluate the value of the companies they are purchasing and the investments that they are making. It doesn’t apply to companies that don’t yet earn money and should be used as just one of the many tools in the investor tool belt.
I hope this simplifies the P/E ratio a bit for you guys, thinking about it in these terms really brought the concept to life for me and helped me to use it a lot more effectively when making investment decisions. Let me know if you enjoyed this content by liking and sharing this post and checking out some of the other content on my blog.
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