P/E Ratios: Part 1

What is a good P/E ratio? Well, good P/E ratios are low. But how low is low enough? Is 20 good? Is 15 good? There are a couple ways to look at this–in terms of a business in general, and in terms of what the markets have determined to be an average P/E in the past. I address historical P/E ratios in the stock market in a future post.

Let’s say you own Acme Brick, and your company makes an average profit of $1 million per year. As the owner, you can pay that to yourself or reinvest it in the business. Let’s say you want to sell, though. What is a fair value? To do this, you need to compare the return that you would make on your business relative to the risk-free interest rate (the rate of interest that you could earn on a U.S. government bond). The rate is now about 5%.

The person to whom you are selling Acme Brick should (at a fair selling price) be able to make a somewhat better return on his money than if he just bought government bonds. This is because he is taking on more risk in buying a company than he would be if he bought government bonds. The company may see its profits shrink, whereas the return on a government bond is guaranteed. So we then fire up a handy interest rate calculator and learn that at 5% interest, it takes about 14 years to double your money.

So what price would a buyer of Acme Brick have to pay so that it would take him 14 years to double his money? He would have to pay $14 million dollars. (In 14 years, his $1 million per year profit would have doubled his original investment to a value of $36 million, including both the company and cash.) I must note that it would actually take less than 14 years for Acme Brick to double the initial investment, because when earnings are paid out each year, they can be invested elsewhere and will thus compound, just like interest on a bond compounds.

Because there is more risk in Acme Brick than in the U.S. government, $14 million is too high, so we subtract some money from his buying price to compensate the buyer for his risk. Therefore, about $10-12 million should be a fair price for buyer and seller. This price translates to a P/E ratio of 10-12. So is this the fair P/E ratio of all businesses? No. In our example, we assume Acme is not growing more profitable. If the company is growing its profits rapidly, a higher price would be in order. However, if the company is becoming less profitable, a much lower price is in order. But the price is always determined from the future profits we can expect from the company. When we take into account the other possible uses of our money, such as buying government bonds, what we have done is an over-simplified discounted cash flow analysis (only the really courageous should follow that link). Again, this is simplified, but the future introduces so much uncertainty that more precise calculations are rarely helpful.

So, with current interest rates very low (around 5% for medium-term government bonds), a fair P/E for a company that is not growing more profitable is about 12. We don’t want to buy companies when they are fairly valued. We want to buy them when they are good values or great values. Thus, for companies that do not show strong growth, we will prefer to pay less than $9 for every $1 in earnings (or, a P/E ratio of 9). For companies with strong growth, we may be willing to pay up to around a P/E of 20 (although the lower, the better).

By paying less than the fair value, we give ourselves a margin of safety, so that we are protected in case we make a mistake in our calculations or in case the company in which we are investing suddenly starts to do worse. Half the battle of making money in the stock market is avoiding big losses, so in buying great values, we are halfway to success.