Price-to-Earnings Ratio - P/E Ratio

Categories: Company Valuation

You just inherited 1,000 shares of whatever.com, which trades publicly for $20 a share, and you also inherited 1,000 shares of Pepsi, which trade publicly for $40 a share. Your sister got the pewter bunny rabbit collection, but uh...you can live with it.

So...what on earth do you do now? What do you do with these things? You have no idea, because you’re an orthodontist, and you have your hands in wet mouths all day. If you’d inherited a truckload of floss, you’d totally know what to do with it.

You check out the brokerage report from Morgan Stanley on whatever.com. It has a hundred million dollars in revenue and no earnings. Earnings = revenues from whatever’s app sales at a buck each (100 million of them) minus its cost of goods sold. It had to pay 50 million bucks to Apple and others to get its apps out there. Then it had a small army of engineers and product people on payroll to build the app. Subtract another 30 million bucks. Then it had rent and legal expenses and healthcare insurance and office things, like computers and servers. All of that added up to be $20 million. So it had $100 million in revenues, and $100 million in expenses, and no earnings. But it has 50 million shares outstanding, which, when multiplied by the 20 bucks a share the market is paying for it, gives it a market value of a billion bucks. Oh and it has $50 million in cash on the books, and no debt. So the market is valuing the equity of the company at $950 million.

So you wonder, orthodontist and would-be floss-seller that you are, “How can something with no earnings or real profits be worth a billion dollars?” You read through the report, which notes that revenues are growing fast (about 100% a year), and that “the market,” whatever that is, believes that the company will have $200 million in revenues next year and $400 million the following year, and on $400 million, it’ll have $100 million in earnings. It will also produce $50 million in cash along the way, so in 2 years it’ll have $100 million in cash on the books and no debt.

So you ponder. That means that today, at a billion dollars, I’m paying 9 times the earnings expected 2 years from now for the equity value of this company. Is 9 times earnings cheap? Expensive? How do I frame the notion?

Well, the “average” S&P 500 company trades at about 16 times earnings. But the average company is totally different from whatever.com. The average company is like...Caterpillar tractors. It’s mature, unlike whatever.com (and the people who write for Shmoop). It's been around for a century. It has a stable set of buyers. What are the odds people still need tractors to harvest food in 5 years? Pretty good. Whereas whatever.com might have evaporated by then.

What about revenue growth? Yeah, Caterpillar is mature; it grows revenues at only about 8% a year in a good year. And it has a lot of capital expense as well. Every decade or so, it needs a new plant to smelt engines and redo its manufacturing process to keep up with the Joneses. Or rather, the Wus. Oh, and it pays a small dividend. Tough company to compare with whatever.com, but it trades at about 16 times this year’s earnings and will grow earnings slowly. You note that it trades at 15 times next year’s projected earnings and 14 times the following years earnings. So that’s interesting. Caterpillar trades at a higher multiple than whatever.com.

Does that make sense? It’s nowhere near as sexy a company. But it must be the risk; the market is discounting a lot of risk, because the odds that whatever.com doesn't make its $400 million in app sales in 2 years is probably pretty good. So you get it. You’ll keep your shares of whatever.com if you believe they’ll really hit their $100 million in earnings 2 years from now...and you’ll dump ‘em if you don’t.

But what about Pepsi? That’s a company that, financially, sounds a lot more like Caterpiller than whatever.com. The risk of people still drinking highly addictive, caffeinated fizzy water and salted potatoes in 5 years? Yeah, really good odds. Pepsi grows a bit faster than Caterpillar, has a bit higher margins, and acquires competitors all the time, dipping its toes even outside the food and snacks arena, so it has a really big playing field. And there’s that global warming thing. People drink more when it’s hot, right? So Pepsi will earn about 2 bucks a share this year, and it trades at 20 times earnings, or $40. Because Pepsi has long-term distribution contracts with grocery stores and vending machines and other weird places in which it sells its wares, it has pretty highly predictable earnings streams, so when PEP tells the Street that it’ll earn $2.20 next year and $2.40 the following year, the likelihood is very high that it hits those numbers or better.

And on its $2.40 in earnings, at $40, PEP trades at a bit of a premium to the stock market overall. That $2.40 in earnings on a $40 per share price today means that PEP trades at 16.6x 2 years out earnings. The overall stock market trades at 16 times this year’s earnings, and because earnings are growing, it trades at about 15 times earnings 2 years out.

Why all of the comparisons? Because price-to-earnings ratios are just a measure of the value of a company relative to everything else. The PE Ratio is just one metric investors use to measure the value of a company, and the basic foundation of the idea is simple: if you invest a dollar in a company, you want to be paid back either by getting cash distributions coming to you that, over time, are much greater than a dollar, or you want the asset itself to simply appreciate at a healthy, fast pace.

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Finance: What is the Price-To-Earnings R...217 Views

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Finance a lash up What is the price to earnings

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ratio All right You just inherited a thousand shares of

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whatever dot com which trades publicly for twenty bucks a

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share And you also inherited a thousand shares of pepsi

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And that stock trades publicly for forty bucks a share

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Your sister got the pewter bunny rabbit collection but well

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you can live with that fact that you take the

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thousand shares All right so what on earth do you

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do now What do you do with these things Well

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you have no idea Because you're an orthodontist and you

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have your hands in wet mouths all day Well if

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you'd inherited a truckload of floss well then we totally

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know what to do with it All right Will you

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check out the brokerage reports from morgan stanley on whatever

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dot com it has one hundred million dollars in revenue

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and no earnings no profits Well what Our earnings again

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Oh yeah This revenues from whatever's app sales at a

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buck Each one hundred million of them minus its cost

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of goods sold Well it had to pay fifty million

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bucks to apple and others to get it saps out

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There well then it had a small army of engineers

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and product people on payroll to build The app will

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subtract another thirty million box then it had rent in

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legal expenses and health care insurance and office things like

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computers and app servers All of that added up to

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be twenty million dollars and because of the accounting laws

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you have to subtract it all last year Even though

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the app it lasts a long time i had to

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take it all off the top It had a hundred

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million dollars in revenues and a hundred million dollars in

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expenses and no earnings but it has fifty million shares

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outstanding which when multiplied by twenty bucks a share that's

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What the market's paying for it twenty dollars share It

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gives it a market value of a billion bucks Take

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the shares outstanding kinds of market price to get what

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the company's worth at least according to wall street buying

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and selling the shares Oh it has fifty million dollars

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in cash on the books and no debt so the

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market is valuing the equity of the company at nine

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hundred fifty million dollars meaning it's valuing the earnings power

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Of the company in the future in his hands at

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nine Fifty alright so you wonder forth an honest and

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would be flossed cellar that you are How khun something

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with no profits no earnings be worth a billion dollars

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Well you read through the report which notes that the

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revenues are growing really fast like one hundred percent a

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year and that the market whoever that is believes that

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the company will have two hundred million in revenues next

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year and for hundred million the following year and on

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four hundred million of revenues it will have one hundred

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million dollars in net earnings It'll also produce fifty million

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in cash along the way so in two years it

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will have one hundred million dollars in cash on the

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books and no debt If you go back and think

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about that that you could subtract one hundred million from

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the billion and it's the nine hundred million of equity

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value back we'll get All right So you ponder that

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means that today at a billion dollars i'm paying if

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i buy it at twenty bucks a share i'm paying

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nine times the earnings expected in two years Two years

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From now for the equity value of this company huh

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Well is nine times earnings cheap expensive Attaway frame the

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notion Well the average snp company trades it about sixteen

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times two years out earning something like that But the

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average company is totally different from whatever dot com The

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average company is like a caterpillar Tractors or well pepsi's

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kind of average Wells fargo kind of average Well it's

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a mature company unlike whatever dot com and the people

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who write for shmoop but not mature way No Well

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caterpillar has been around for a century has a stable

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set of fires And you know what are the odds

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People still need tractors to mine food in five years

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You have pretty good odds whereas whatever dot com might

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have totally evaporated by them Yeah well what about revenue

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growth Yep Caterpillars matured gross revenues that only about eight

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percent a year in a good year And it has

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a lot of capital expenses Well every decade or so

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it needs a new smelting plant to smelt engines and

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redo its manufacturing process Tio you know keep up with

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the joneses or rather the blues or chains Oh and

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it pays a small dividend yeah helps well tough company

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to compare with whatever dot com but caterpillar trades at

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about sixteen times thiss years earnings and it'll grow earning

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slowly and you note that it trades at fifteen times

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and extras projected earnings and fourteen times the following year's

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earnings So that's interesting caterpillar trades at a hire multiple

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on two year forward earnings than whatever dot com who

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does that make sense It's nowhere near ist sexy a

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company but it must be the risk the market is

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discounting a lot of risk because the odds that whatever

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dot com doesn't make its four hundred million dollars in

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projected app sales in two years well that's pretty good

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could earn a lot less so you know you get

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it You'll keep your shares of whatever dot com if

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you believe they'll really hit the one hundred million in

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earnings on four hundred million of revenues two years from

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now and you'll dump the shares if you don't Well

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what about pepsi Well that's company that financially sounds a

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lot more like caterpillar than whatever dot com the risk

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of people still drinking highly addictive caffeinated fizzy water and

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salted potatoes in five years left pepsi sells a lot

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of data chips Yeah really good odds Pepsi grows a

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bit faster than caterpillar it has a bit higher margins

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and it acquires competitors all the time dipping its toes

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even outside the food and snacks arena So it has

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a really big playing field that it plays on by

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a lot of things and there's that global warming thing

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People drink more when it's hot right So pepsi learn

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about two bucks a share this year and it trades

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that twenty times earnings or forty dollars Well because pepsi

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has long term distribution contract with grocery stores and vending

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machines and theme parks and other weird places it sells

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its wears well pepsi has a pretty highly predictable earning

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stream So when peopie tells the street that it'll learned

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to twenty next year in two forty the following year

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what likelihood Very high that it hits those numbers are

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maybe does little better because it has a history of

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under promising and over delivering and on its two bucks

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forty and earnings at forty dollars pep trades at a

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bit of a premium to the stock market overall that

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to forty and earnings on a forty dollars a share

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price today means that peopie trades at sixteen point six

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times two years out Earnings well the overall stock market

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trades at sixteen times this year's earnings because well earnings

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are growing It trades it about fifteen times earnings two

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years out Why all of these crazy comparisons That air

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probably confusing you well because price to earnings ratios are

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just one measure of the value of a company relative

07:05

to everything else The p e ratio is just one

07:09

metric investors used to measure the value of a company

07:13

and the basic foundation of the idea is simple If

07:16

you invest a dollar in a company today you want

07:19

to be paid back either by getting cash distributions coming

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to you That overtime are much greater than that dollar

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you put in like big dividends and so on Or

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you want the asset itself to simply appreciate it A

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healthy fast pace about eight dollars worth of stock Well

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you want that stock to double every you know three

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four five six years something like that Alright we'll announce

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for your sister's rabbit collection Well that things should multiply

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At a good rate too unless she decides to separate 00:07:47.975 --> [endTime] them

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