You’ve heard it all the time: “Buy when the P/E ratio is low”, but what is a low P/E ratio?
Never mind that, what is the P/E ratio exactly?
Sure, we know that it stands for Price to Earnings – but what does it really mean?
Let me explain
Let’s say you’re looking to buy a business, and you know said business generates $100K annually. How much will you buy it for? Obviously, the lower the price the better. If you buy it for $100k, it will take you only one year to make back what costed you. In this case, the P/E ratio is a solid 1.0x (price to buy the business divided by annual earnings: 100k/100k). But who in their right mind will sell it to you at that price? Well, no one.
So let’s make it a bit more enticing for the seller.
Let’s say we’re looking to break even in 5 years, then you would offer $500k (P/E of 5x), so any income that this business produces after 5 years, is pure profit.
But… it doesn’t stop here.
You also expect earnings to grow at 20% every year for the next 5 years, which will bring you an aggregate of $892k earnings. So how much are you willing to pay now? If the business is expected to generate $892k earnings and it is producing $100k now, you would be willing to pay at least $892k now. So, the price to earnings is 8.9x
Enter Joe
Joe is also another buyer and like yourself he wants to know how much he should pay for this business. However, Joe views the business differently than you do. In his mind, the buck doesn’t stop at 5 years. If he knows the business will continue generating profits for more than 5 years, he might offer a higher price for the business. Joe also has done his own analysis and he thinks earnings will grow at 10% after the 5th year for another 5 years, so Joe is now willing to offer a P/E of 25x.
Now imagine that there are thousands and thousands of Joes and Janes out there who have their own views of this business and therefore their own conviction of the price it should be bought at. This is the reason why P/E varies every day. When investors are pessimistic about a business’s prospects they will not pay such a high premium. Alternatively, if they are optimistic about its earnings, like our friend Joe, the market will offer a higher P/E.
To summarize
Your job, after having done your own due diligence, is to buy when the P/E ratio is lower than what you are willing to pay and the P/E ratio will sway because the market (our many Janes and Joes) is emotional and changes its mind every day. You just have to be patient.