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Author: TMFSandman Big red star, 1000 posts Feste Award Nominee! Old School Fool Coverage Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 27464  
Subject: Re: P/E Ratio Date: 10/20/2012 2:15 PM
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Scissortail51,

The PE ratio gives you a rough idea of how many years it would take you to break even on your investment if the company kept on earning what it’s earning today (i.e. earnings didn’t grow or shrink). Truth is, most companies are growing earnings as they expand, make acquisitions, become more profitable, etc. On top of that you have external economic effects like inflation and population growth.

So yeah, it would take you 15 years to break even on a company you buy at a PE ratio of 15 only if that company was a zero growth company. In reality there's a good chance it will be less than 15 years if you can expand that company in the interim.

And that's why high growth companies can sport those high PE ratios. If a company is growing earnings at 30% likely it could be sporting a PE ratio north of 40. Will it take 40 years to break even? Definitely not if the company can keep growing earnings at 30%. At 30% growth your earnings will double in just three years. Even if you had zero growth after those three years your payback time from that point would have shrunk from 37 years to just 19.

That said, everyone knows that 30% growth is unsustainable in the long term. The thing that no one knows is when precisely that growth will stop. The more optimistic people will assign a higher PE multiple since they think that high growth period will last longer than the more pessimistic people. When there get to be many more optimistic people than pessimistic people, the PE ratio will expand. There's nothing wrong with buying a company with a 30 PE multiple if you're pretty certain of continued high growth rates or if the "E" in the PE ratio is trough earnings, set to recover. But those determinations have to be based on conservative estimates based on data specific to the company, not on hopes.

When you get to have very many more optimistic people than pessimistic people the PE ratio for the entire market can expand. Case in point: in 1999 the PE ratio for the S&P 500 index got as high as 44! The long term multi-decade average of the S&P 500 index is more around 15. At that point you have to look at the market with extreme suspicion. Why would some of the largest, oldest companies in the US be able to sustain such super-normal growth rates for the amount of years required to justify such a PE multiple? What are the odds of that really happening?

Even if two companies are in the same business and have similar growth profiles they might still have different PE ratios. Maybe one company is using more debt than the other company and is viewed in many investors’ eyes as a bit less safe, so I gets a discount price. Maybe management at one company has stumbled in the past and investors don’t trust them as much as management at another company. There are many reasons why the market at any point in time thinks either the market or a specific company deserves a discount or a premium to its historical valuation. Your job as an investor is to find out what those reasons might be and whether or not you agree with them.


Mike
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