[Guide] Why I Love the Price-to-Earnings (P/E) Ratio and How I use it to Value Stocks
Why the P/E ratio is so powerful and how I use to it motivate if a stock is over- or undervalued
When I analyze stocks, I put a lot of emphasis on their Price-to-Earnings (P/E) ratio:
The reason is because the P/E ratio is the simplest way to get an indication on how expensive or cheap a stock is.
To get an understanding on why the P/E ratio is such a powerful formula, it simply tells you how long it would take for a company to buy back itself with its earnings if they stayed the same every year.
If a stock has a P/E of 15x, it would take 15 years for the company to buy back itself with its earnings. Of course, this is a simplified version of reality, but it gives you a good image on how hyped the company is.
However, the P/E ratio has some serious drawbacks, with the biggest one being that it does not accounting for a stock’s growth prospects. If the company is growing quickly, you will be comfortable buying it at a high P/E ratio, knowing that growth in Earnings Per Share (EPS) will bring the P/E back down to a lower level.
Even so, let’s say a company has a P/E of 100x. That means it would take 100 years for the company to buy back itself. Sure, it can be a very cool company with great potential, but more likely, the hype surrounding it has made people too optimistic about its future.
How I Motivate the P/E-Ratio of a Stock
When I value stocks with the P/E ratio, I embed their profit growth potential and my required rate of return based on the company’s risk.
With an assumed lifetime of 15 years, a motivated P/E ratio can be given by computing the present value of profits, given your Required Rate of Return (RROR) and profit growth:
Required Rate of Return is how much you as a shareholder expect the stock to rise every year for 15 years
Profit Growth is how much the company’ profits are expected to grow every year for 15 years
Let’s use this formula on Coca-Cola:
Coca-Cola is trading at $60.76 on 28 Oct 2022.
Its P/E ratio is 26.64x.
Its annual operating income for 2021 was $10.308B, a 14.57% increase from 2020, and for the past 5-years, its profit growth has been around 15%.
If we assume that Coca-Cola’s profit will grow at the same rate as it has for the past 5-years, its Profit Growth is 15%.
To get a Required Rate of Return (RRoR) for the company, let’s take the US stock market as a base value. The average rate of return for the US stock market in the past 30-years is around 10%. We can assume it’s riskier to own Coca-Cola than a stock market index, so I set the RRoR at 15%.
With a 15% Profit Growth & a 15% RROR, we get:
As the graph above shows, the motivated P/E-ratio for Coca-Cola is 15x. However, as its actual P/E is 26.64x, the Coca-Cola stock is overvalued.
Conclusion
As I’ve hopefully convinced you in this article, the P/E ratio is an incredibly powerful formula to sort out value-stocks from overhyped stocks. However, it is just the beginning of a stock analysis.
There are many other factors that have to be considered to get a real understanding of a stock’s value, but I believe this is the best method to find stocks that belong in the bargain bin, and stocks that should be thrown in trash-bin.
I am not so clear in how you compute every entry in the matrix. For example: for a profit growth of 25% and a RRoR of 5% the entry is 79. How is 79 obtained?