Good morning & happy Monday!
“If you can follow only one bit of data, follow the earnings – assuming the company in question has earnings. I subscribe to the crusty notion that sooner or later earnings make or break an investment in equities. What the stock price does today, tomorrow, or next week is only a distraction.”
– Peter Lynch, American investor & mutual fund manager
Last week I got a little carried away about business profits and the amazing opportunity we as investors have to take part in the profits of amazing businesses through ownership in company stock.
Today I would like to talk about one of the most fundamental of investing concepts: price to earnings, also known as P/E ratio.
P/E ratio helps us as investors determine what price we are willing to pay for an ownership stake in a business.
As with many things within the investment space, this can get a bit complicated, but I will try to not get as carried away as I did last week, but no promises. 😉
Let’s pretend that Intentional Wealth generates profits of $1,000,000 per year. This is completely hypothetical (but I can dream, right? 😉)
If someone were to knock on my door and say they would like to purchase Intentional Wealth and they would offer to write me a check for $1,000,000 would I accept that offer? No way! The business makes $1,000,000 a year, why would I sell the business for 1 years’ worth of profits? I could simply work one more year and make that amount. I would tell this person to get lost!
If I accepted the offer (which I would be a fool to do) the P/E ratio would be 1 – the buyer is paying 1 year of business profits for the business.
Now, what if I turned down that first offer and someone else came along and offered me $100,000,000 for the sale of Intentional Wealth … what would I do then? It would be a no-brainer to sell the business … this person (business) is willing to pay me 100 years’ worth of profits! I would have to work 100 years to generate that amount of income. Tell me where to sign! 😊
If this offer came along, the P/E ratio would be 100 – the buyer is paying 100 years of business profits in order to take over ownership.
So, a P/E ratio of 1 is way too low, but a P/E ratio of 100 is way too high. What is a fair number? That is where things get quite a bit more complicated.
Depends on not just the business, but the business outlook, the economic environment, the industry, and expected earnings growth … just to name a few of the factors.
As a reference point, at the end of the first quarter in 2023 (March 31, 2023) the average forward P/E ratio of the S&P 500 was 18.0 (see attached slide for more details). That means that investors are willing to pay 18 years of profits for the ownership of the S&P 500. Now, there are plenty of individual companies in that index that have higher or lower P/E ratios, but that is the average as of 3/31/2023.
As an investor let’s say you could choose between one of two investments:
- Investment #1 – company has been around for 100 years and makes consistent, predicable profits, in a stable industry where profits will probably grow around the rate of inflation.
- Investment #2 – company has been around 10 years and only recently has turned profitable but has projections to make significant profits in the years ahead in the technology industry.
Which one do you choose?
I probably would think investment #2 because of the greater growth potential.
But what if company #1 has a P/E ratio of 15 and company #2 has a P/E ratio of 40? See where things quickly get complicated?
Apple recently made headlines for becoming the most valuable company in the world. Apple’s P/E ratio is currently around 30. That means that investors are willing to pay roughly 30 years of current profits to take an ownership stake in Apple. If Apple made $1,000,000 a year, then the company value would be $30,000,000 at that P/E ratio of 30.
Compare that to General Motors (GM) who has a P/E ratio hanging around 5.5. That means that investors are willing to 5.5 years of profits to take an ownership stake in GM. If GM made $1,000,000 a year, then the company value would be $5,500,000 at that P/E ratio of 5.5.
So why is Apple roughly 6 times more expensive than General Motors? The overly simple answer is that investors believe that Apple’s future growth warrants the higher price, and that GM will not be able to maintain profit at current levels. Apple is changing the world and investors believe that greater profits will be ahead for the company, so they are willing to pay a premium to be an owner of this ground-breaking company. GM on the other hand is having to make significant investments to transform their fleet to electric vehicles and investors are concerned that competitors such as Tesla may drive GM’s profits lower going forward.
Does that mean Apple is good and GM is bad? No. GM is cheaper, does that make it a better investment? Not necessarily.
The “cheapest” stock in the S&P 500 is DISH Network, which is trading under 2.5. Investors don’t believe that company has long-term profitability sustainability, so that is why it is cheap.
What about Amazon, which trades above 300 P/E? Investors believe that Amazon’s profitability is significantly greater going forward and are willing to pay 300 years of current profits in order to acquire an ownership stake.
Does your head hurt yet? 😉
So many people focus on the stock price (“The stock hit $50 a share this week”), but I am far more concerned with P/E ratios than I am with the stock price when evaluating when to buy, hold, or sell positions in our portfolio.
As a side note, at Intentional Wealth we generally do not recommend or purchase individual stock or bond holdings, instead we utilize ETF and mutual fund strategies in order to benefit from diversification and allowing the experts within those companies we partner with to make individual security selections. We go through a rigorous screening process to determine which fund families, funds, and strategies we will employ for your benefit.
Sorry if this is overly boring or technical, but I just wanted to share some insight into the exceptionally important investment factor of price-to-earning as it is one of the most important components of our investment strategy and structure.
As always, I am glad to discuss further so please don’t hesitate to reach out.
Hope it’s a wonderful week ahead!