Price-to-Earnings Ratio - P/E Ratio
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.