He forgot that the complete formula would be something like...
"Value" = P/E
not, value is value/E.
I find Graham's estimate quite invaluable. Reverse it as he recommended and it does give a pretty good idea of what the market is expecting the company to grow at.
Some companies market price imply a very high p.a. growth rate. It's good to have an idea of what the business has, and can, delivery vs what is expected.
Too high an expectation and a slight disappoint or setback will see the price getting smashed like the business is going out of business tomorrow.
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Indeed Ricky you can pay a seemingly outrageous p.e. ratio and still receive a good return if a company can compound its earnings at high rates of return for a long time.
For example let's say an investor at age 20 buys shares in company Widget Corporation and that he lives to 100. So he therefore holds the shares for 80 years. Let's say widget corporation has a 15% return on equity and it reinvests all of its profits every year and pays no dividends. The return on equity always remains at 15% and therefore earnings per share compound at 15% per annum. Let's say the investor pays 100 times earnings for the stock (i.e. a p.e. ratio of 100).
If at the end of the 80 years the growth rate of the company falls and the stock then trades at a p.e. ratio of 10 instead of 100, what will the investors annualized compound return be over the 80 year period? The investors return will be around 11.7% per annum compound which is still a very respectable return.
Of course in reality few companies will survive for decades let alone maintain a high growth rate, but the point is that if a company can indeed maintain high return on equity and high growth for an extended period you can pay a seemingly very high p.e. and sill get a good return.kid hustlr likes this.
I remember reading Peter Lynch saying that, paraphrasing... the PE tells him how many years it'll take to return his money. Payback period.
Can't remember if he said it directly or that's what I read into it. But it makes sense to me.
Maybe that's just being simplistic but if we see ourselves as business owners, doesn't the company's net profit p.a. mean the price we paid for it will take x years to return the initial investment?
I did try to work out the ROC etc., and its relationship to PE or the price... never managed to work it out. I can kind of see how ROC/ROE could link to the eventual price, but I can't directly link to it. So settled for it being an indicator of the quality of the business itself rather than a direct mathematical relationship to the price an investor should pay.
btw, maybe change your analogy to driving a car. More people drove than ply planes.
Hi luutzu, if a paper is 0.1mm thick, folding it 50x will be 2^50, or 1.12 with 15 zeroes behind. Lynch did say something like that, probably in 'One Up on Wall St' but I never grasp the actual meaning behind it. Yea car might be a better analogy than plane lol.
PE ratios are really useful but you must correlate them with growth to work out value.
CSL was down to a PE of 20 some months ago, I bought more because considering the growth, that's cheap. It's the E that's hard work, not the P.