Posts made in June, 2008
The P/E Ratio Part 3
Continuing from The P/E Ratio Part 1 and The P/E Ratio Part 2…
So far we been using some unlikely assumptions, namely that this fictitious company we are going to buy has a constant earnings stream and that there is no risk involved in that earnings stream. Of course the real world is quite different! Let’s next decide on how a changing earnings stream can affect the present value of all those future annual earnings.
The Math is Not Much Different
The math is not really different, we just have to take an extra step. Before, we were just assuming that a company would produce $1 in annual earnings forever. But let’s now pretend that our company is expected to grow it’s earnings by 10% per year. Therefore, instead of an earnings stream that looks like this:
Year 1: $1.00, Year 2: $1.00, Year 3: $1.00… etc.
It will instead look like this:
Year 1: $1.00, Year 2: $1.10, Year 3: $1.21… etc.
If we just do the math for the first 3 years, you will get the picture of how a changing earnings stream can affect a price someone is willing to pay for a company. If you recall from Part 2 of this series on the P/E Ratio, we need to figure out what we need to invest TODAY at 3% (or whatever the “risk-free” rate of return is) to replicate the earnings that will be earned at some point in the future. In our new company here that grows it’s earnings at 10% per year we find that we might pay $1.00 for this years $1.00. But it is going to earn $1.10 in the second year – so what amount of money invested today at 3% will give us $1.10 in one year? The answer is $1.07. Likewise for the $1.21 it is expected to earn in Year 3 – what amount do we need to invest today at 3% in order to replicate that $1.21 in two years from now? The answer is $1.14.
At this point, I could show a revised graph which shows the present value of the income stream for a company that can grow it’s earnings at 10% forever, but not many companies can do that. What is more realistic is to look at the following situation:
A Hypothetical Company’s Life Cycle
Suppose we have a relatively new company that is turning a profit and is still in it’s growth phase. During this growth phase it is expected to grow it’s earnings at 20% per year for 5 years as it gains market share and more customers. After the first 5 years, earnings growth slows down to about +10% per year for the next 5 years, and then slows down to +5% for the next 5 years. At this point, it has reached it’s market saturation point and perhaps earnings hold steady for the next 10 years. During that time, some competitor companies figure they can take a slice of their market and start up operations, and over time start to move some customers over away from “our” company. Our company therefore experiences an earnings decline of -5% per year for the next 10 years. At this time, our company and the competitors have found an equilibrium point and our company’s earning are now not declining further, nor are they increasing from this point on until the end of the 80 years.
The above Life Cycle might represent a more realistic earnings stream for a real-life company. Now that we have a projection of what the future income stream might look like, we can again add up all the present values of those annual earnings to figure out a fair price for those earnings. I have charted both the annual earnings (in red) and the present value of those future earnings (in green).
If we add up all the present values this time we get a sum of $71.81. This is quite a bit higher than the $30.20 we came up with in part 2, but remember part 2 assumed $1/year for 80 years. Whereas in this case, the earnings grew from a start of $1/year to as high as $3.55/year, and then declined to about $1.56 per year. So you can see how earnings predictions are so important and why the market seems to be so sensitive to them.
What About The Business Risk Preet?
Ah, yes. Again we have yet to factor in that if we were to offer $71.81 for this future earnings stream, we are assuming there is no risk involved – and of course, this couldn’t be further from the truth. There is the risk that this company goes out of business due to competitors, their product could be rendered obsolete by new technology, a poor economy in general, you name it. Any of those things could affect future earnings and there is a risk that our predictions for the income stream may not be fulfilled. We could put our $71.81 in a high interest savings account at 3% and basically replicate this earnings stream with no risk, therefore we would be crazy to offer $71.81 for this company – we would have to offer LESS money for this expected income stream to compensate us for this extra risk.
If you offered $40/share for something you have calculated to be worth $71.81 today, this discount represents the compensation for the risk you are taking. The constant bids/asks on the stock market for shares of companies are basically people weighing in on what their perception of a good discount is for that future earnings stream for those particular companies.
I’ll end Part 3 there, and Part 4 will conclude by tying it all together and giving a more realistic sense of how P/E ratios are used in the real world.
The P/E Ratio Part 2
If you recall from Part 1, I mentioned that one way of looking at the P/E ratio is to consider it as the price today of purchasing a $1 income stream for life. When people bid up a stock, and hence the P/E ratio, they are basically saying that they believe that company’s future earnings outlook are more promising, and are willing to pay more to own a piece of those future earnings.
So What’s A Fair Price For A Company?
Let’s assume we have a company that is guaranteed to provide $1 per year for life no matter what (i.e. there is no business risk whatsoever – purely wishful thinking!). In this case, what would be a fair price to purchase that income stream? Well, if we assume that we are going to live for another 80 years, then you might say $80 as a starting point because 80 years times $1 = $80. You would think, I’m going to get $80 over the next 80 years – therefore this is the fair price. Right?
Wrong.
The Present Value of a Dollar From the Future
You are essentially giving up $80 now in a lump sum today in exchange for getting eighty $1 dollar payments over 80 years which is crazy when you think that you could just get a high interest savings account and get 3% interest on your $80 lump sum starting today. In fact, the first year’s interest alone would be $2.40 – that’s much more than $1. And after 80 years, your original $80 dollars would’ve grown to $826.48, if you kept re-investing the interest.
Let’s start by figuring out what a better price would be to pay for $1 that will be received in the future, starting with next year. Basically, we need to start by asking: What do I need to invest at 3% today, to get $1.00 in one year?
In this case, the answer is $0.97 (rounded). In other words, to have $1.00 NEXT year, you would need to invest 97 cents into that 3% high interest savings account. Therefore, you might pay $1 for this year’s $1 income from the company, but you would definitely not want to pay more than $0.97 for next year’s $1.
Let’s move to year 3. What would you need to invest TODAY at 3%, in order to get $1 in 2 years? The answer is $0.94 (again, rounded for simplicity’s sake). $0.94 invested for one year at 3% equals roughly $0.97, which when invested for the second year at 3% will give you $1.
So you can see, the further out that company’s $1 annual income is, the less you would want to pay for it. If we fast forward to year 80, you would only need to invest 9 cents today in order to have $1 eighty years from now.
Below, I have charted the present value of $1 for every year between now and 80 years from now, based on a 3% interest rate. If we add up all of those values, we then have $30.20. Therefore, assuming there is no business risk, and we are guaranteed an earnings of $1.00 per share every year for the next 80 years, $30.20 per share is a much fairer price than $80.00 to pay for this income stream. (If you can’t see the graph, click here.)
Still Not Done!
We are not quite yet done with the discussion. There are two more things we need to factor in. 1) Investors expect to be compensated for the risk they take in making an investment that is more risky than a high interest savings account (this would bring the price that they are willing to pay DOWN), and 2) the price goes up if the company’s earnings are expected to increase. We’ll cover these off in the next post and then we will wrap up with a fourth post that explains some real world applications (I had originally thought I could do it in three posts, but I wanted to be thorough).
A Lap Of The Blogs
If you are a daily reader, you will know that I’ve been experimenting with some alternative delivery methods, such as the video entry on private equity and the video tutorial on looking up a stock quote. Well, starting soon I’m also going to start pod-casting. Look for an iTunes podcast feed to launch (as soon as I figure it out). This will allow people to download the feeds and listen to them on the way to work on their iPods (I think). :)
From Around The Blogosphere
Jonathan Chevreau talks to Norm Rothery about how $10 trade commissions present some interesting portfolio options.
The Quest For Four Pillars explains how anyone can probably create an extra $30 in passive income starting today.
I’m convinced Tim from Canadian Dream: Free at 45 has figured out life almost completely. Read him explain how he thrives on $35,000/year.
The Canadian Capitalist explains how you can deposit Canada Child Tax Benefit or Universal Child Care Benefit payments into an account in your child’s name and have the interest payments treated as your child’s income.
Thicken My Wallet talks about your options when you owe money to creditors but cannot pay them.
Larry MacDonald talks about the conflict of interest real estate agents are exposed to.
Michael James on Money further expounds on the alignment of interests between two parties.
And last but certainly not least, FrugalTrader from The Million Dollar Journey talks about 10 ways you can save big bucks on campus.
This Week’s Racing Video
If you are new to WhereDoesAllMyMoneyGo.com, you should know that every Friday I post a ‘Lap of The Blogs’ which links to other articles of interest from around the internet. I also include an auto-racing video simply because cars and racing are my other passion. This week’s video isn’t actually a racing video, but rather is the future of the automobile should oil prices continue to rise. It highlights a car that 1) gets 100mpg 2) fits in an elevator and 3) has a top speed inversely related to your weight. :)
Read MoreThe P/E Ratio
During yesterday’s Video Tutorial on How To Read a Stock Quote, one of the items pointed out was the P/E Ratio. I purposely skipped over giving an explanation as it would’ve taken the 10 minute tutorial to about 20 minutes! However, today I will follow up on that promise to explain it in more detail.
The P/E Ratio, also known as…
The P/E Ratio is such a widely used ratio that it has many different slang terms such as:
1. The Multiple
2. The Price to Earnings Ratio
3. The P/E Ratio
4. Earnings Ratio
5. Price Multiple
…and there are probably some others that aren’t top of mind right now, too.
Okay, so what is it?
The price to earnings ratio is a number that is derived from the formula:
P/E Ratio = Price Per Share / Earnings Per Share
So the “P” stands for the Price of the share, and the “E” stands for the Earnings Per Share (or ‘EPS’). If you had a stock that was trading at $50 per share on the market, and that stock had an EPS (earning per share) of $2.50, then according to this very simple formula, the P/E Ratio of this stock is 20.
But seriously Preet, what IS it?
There are a number of differet ways to look at it, but I will give you the one that makes the most sense to me. It is the price you are willing to pay today for $1 of annual income in perpetuity. So for example, for our sample stock above with a P/E of 20, that means you are willing to pay $20 today for an annual income stream of $1 for life. (It might be better to say that the market as a whole is willing to pay $20 today for that $1 annual income for life.)
I’m going to borrow an example I read elsewhere, but if a stranger came up to you and asked you to buy a $1 dollar income stream from them for life, you would have no idea if they were able to keep this promise and you might only offer them $1 simply because you don’t know or trust this person, but you think that you should be able to at least get your $1 back next year. But what if Bill Gates came up to you and offered to sell you $1 per year for life for $20? You might take him up at that price because you know that he will probably be making a lot of money for many years to come. Well, in essence Bill has a P/E ratio of 20 and the stranger has a P/E of 1.
Your expectation of Bill Gates earning lots of money in the future is solid and hence you are willing to basically wait 20 years to get your money back, at which point the future $1 annual income is gravy. (Clearly I’m not factoring in opportunity costs or interest for this example – but I will in a follow up post that is a bit more technical.)
Let’s now relate it back to the stock market
A high P/E ratio means that investors believe the future earnings of a company are expected to be strong. The stronger the earnings outlook, the more confidence people have in buying stock in the company because they believe there is a greater chance that the earnings will continue.
If someone offers to pay a higher price for a stock, they are offering to purchase the stock at a higher P/E ratio – which means they are more confident about the future of that company.
But there’s more…
When a P/E ratio really starts to get high this is due to investors not only believing the earnings are solid, but that they will probably GROW over time as well. This means that they are basically saying to themselves that they believe the $1 annual income stream will increase. Next year it might be $1.05, the year after it might be $1.12 and so on. Since they believe the earnings will grow (because the company is going to take off), they are willing to offer an even higher ‘multiple’. For example, RIM has a P/E of over 60 right now. If you only assume that you are buying $1 of annual earnings per year for $60 today, that might seem a bit crazy. But if you think that RIM will continue to increase it’s earning VERY rapidly, then you are not expecting $1 per year, but rather a very quickly increasing earnings stream.
I’ll end this primer here, but will continue in more detail with two follow up articles. One will explain in more detail how the increasing earnings expectation will affect the price someone is willing to pay for a share (and hence the very high P/E ratio), and the second will explain how to interpret the P/E when evaulating a stock and gauging the market sentiment overall in a more common manner.
Read MoreHow To Read A Basic Stock Quote
I think I’ve made the mistake of not putting enough “foundation knowledge” posts on this blog (and perhaps not appealing to a larger audience), so you’ve probably noticed that I’ve been experimenting with topics that have more mass appeal – like the posts on Price Vigilantes and Market Mavens for example. Along that vein, I decided to not only change the look of the blog, but also to change up the content slightly. I’m still going to post technical articles (such as the reverse dispersion equity collar), but I’m also going to include video blog entries (like the one on private equity) and starting today: Video Tutorials!
So without further ado, here is a video tutorial on how to look up a stock quote on the internet and further, how to interpret the basic data. I’m using Google Finance in this tutorial, but I’ll use many other tools in the future as well. (Feed and Email readers: click here if you cannot see the video)
I really would appreciate your feedback as I plan on incorporating video tutorials on this blog more heavily in the future, and would like to know how to make it as good an experience as possible for the great readers of this blog. So? What do you guys think?
Read MoreThe Storm Before The Storm (As opposed to the calm)
In reference to the old adage, “the calm before the storm” – the stock markets tend to have good storms right after the bad storms. By this I mean that equity markets have a tendency to rebound fairly strongly after adverse market conditions.
Unfortunately, many investors bail out of their investment portfolio strategies during the bad storms and forego the market appreciation while watching from the sidelines. Of course, it can be very difficult watching your portfolio see-sawing back and forth so I thought I would ask Russell Investments for permission to post a fantastic chart they have that might help you “batten down the hatches” and focus on the long term…
(Note – you can click on the picture for a larger version. For email subscribers, please click here to view the photo if it does not appear.)
Many thanks to Russell Investments Canada Limited for permission to post this.
Read MoreGroceries At Eye Level Cost More
Have you ever noticed that your local grocery store has all the milk and eggs at the very opposite end of the store as the entrance? This may be because you will have to walk by more items before grabbing the ones you want, which means you are more likely to buy more.
Product manufacturers can also pay grocery stores to place their items on the middle shelves since people spend more time looking at items placed at eye-level, and hence are more likely to purchase them. In aisles with products that may appeal to children, these items may be placed at their eye-level, i.e. on the lower shelves.
It would seem that supermarkets have spent lots of money on hiring psychologists and marketers to make more money from consumers – and it seems the investment was worthwhile. They go so far as to analyze the probability of turning left versus right upon entering a store so that they can place higher priced items on the path most traveled – so that by the time that you have made your way through most of the store you will be getting to the lower cost items. Based on having seen the higher priced items earlier, the lower prices on the smaller items comparatively seem like a bargain, and you are more likely to purchase more of both if you start by seeing the higher priced items first.
You can read more about slotting fees here.
Read MoreFollow Preet for free
+ followers on Twitter
1571+ Email suscribers
543+ Facebook fans
3003+ RSS feed readers
Recent Comments