The PE Ratio - Its Importance as an Investment Tool

We believe that one of the most important and useful tools for the serious investor, is the price earnings ratio or PE. It is, however, one of the most misunderstood and misused tools. We believe that learning how to use it properly and understanding its importance can significantly increase returns and lower risk. Perhaps the most important thing to realize when using the PE ratio as an investment measurement is the PE ratio by itself is virtually worthless. The PE ratio is only truly important when thought of in relation to the respective company's earnings power, past, present and future.

Therefore, the true value of the PE ratio is as a barometer or measuring device used to calculate and measure important investment metrics relative to each other. Unfortunately, we have found that many, if not most investors, fail to realize this and therefore miss the long-term benefits that PE's offer. On the other hand, when the PE ratio is thought about and used properly, it can greatly assist the investor in the rational evaluation of the realistic probabilities of achieving a long-term rate of return and the amount of risk taken to get there. In short, when used properly, the PE ratio can help investors ascertain both current and future valuation.

The PE Ratio Defined

A great way to gain a deeper insight into the value of a PE ratio is by evaluating several common definitions where each provides a different perspective and greater clarity. In other words, the PE ratio can be defined in several ways, with each definition adding insight into its usefulness. For purposes of this article, we will offer three of the most common PE ratio definitions as follows:

1. The simplest and most common definition is the price of the common stock divided by its earnings per share. This basic mathematical definition is expressed as follows: price/EPS = PE ratio. Although this definition is the mathematically correct way to express a PE ratio, we believe it adds very little insight into the relevance of the PE ratio.

2. A second commonly used definition that we believe offers deeper insight is: The PE ratio is the price you pay to buy one dollar's worth of the company's earnings or profits. For example, if a company's stock has a PE ratio of 10, then you are paying $10 for every dollar's worth of that company's earnings or profits you buy. If the company's PE ratio is 20, then you are paying $20 for every dollar's worth of the company's earnings or profits, and so on.

This second definition more clearly addresses the cost of the earnings the investor is purchasing. However, as we will later elaborate, a PE of 20 may not necessarily be more expensive than, for example, a PE of 15. If the company with the higher PE is growing significantly faster, it is simultaneously generating a much larger future income stream. And thanks to the power of compounding, the investment with the higher PE of 20 may be actually purchasing future earnings much less expensively than is the investor that is buying a much slower growing company at a PE ratio of 15. This provides insight into the concept that the PE ratio is a relative tool.

How much you are actually paying for future earnings is a function of how fast current earnings are growing. The faster a company grows, the larger will be the future income stream to discount. Therefore, a faster growing company will logically be worth more than a slower growing company, and as a result, command a higher original price or valuation. This relationship to a company's ability to generate earnings and cash flows on behalf of its stakeholders is a critical element towards understanding fair or intrinsic value. However, it's also important to add that the stock market (Mr. Market), at any given moment in time, may not be applying a PE ratio to a company that reflects its intrinsic value.

This is why it's so important to understand the dynamics behind what the PE ratio is actually supposed to reflect. In other words, it behooves the investor to be able to recognize whether the current PE ratio reflects fair valuation, overvaluation or undervaluation. The simplest way to do this is to measure the current PE ratio relative to your most reasonable expectation of the future growth of the company's earnings. The best way to do this is to utilize established formulas for valuing a company's future cash flows. In essence, these formulas answer the question: What is the present value of a given expected future stream of income?

3. Our third and final definition is: The PE ratio states how many years in advance you are paying for this year's earnings. For example, if a company has a PE ratio of 20, then you are paying 20 times this year's earnings to buy it. If the PE ratio is 10, you're paying 10 times this year's earnings, and so on. The key to understanding the significance of this definition is based on the simple premise of how an operating business derives its value. The foundation of this premise is that a business generating an annual revenue stream for its owner has a value greater than one year's worth of profits.

The question then is; How much more? Here are a few clues; the yield on a 10-year Treasury bond has averaged 6.1% since 1950. Therefore, even the no growth income stream from a Treasury bond is worth 16 times its annual income (cost of 100 divided by average yield of 6.1% equals 16.4 price to interest ratios). Also, the average PE ratio of the S&P 500 has been approximately 15. In other words, a no, low to average growing revenue stream is hypothetically worth at least a multiple of between 15 and 20 times.

Using the PE Ratio as a Measurement of Valuation

Now that we have offered our three definitions of the PE ratio, let's evaluate how we can use this information to become better investors. In other words, we now know what a PE ratio is, but what we need to know is how to effectively use it to make smarter investment decisions. There are several factors that come into play here, most of which are mathematically based, while others are based on commonsense realities that cannot be ignored. However, in all cases the real value of the PE ratio comes with using it to measure the cost or price you are paying to purchase your expected future income stream (earnings). Obviously, just like buying anything else, the cheaper you can buy future earnings, the better. But most importantly, this establishes the need and the necessity for investors to forecast future income streams as accurately as possible.

Forecasting Future Earnings is the Key

As an investor, forecasting future earnings is the key to long-term success. We cannot escape the obligation to forecast; our results depend upon it. However, our forecasts should not be mere prophecy, and we should not be simply guessing. Furthermore, forecasting should not be about playing hunches, instead investors should be attempting to calculate reasonable probabilities based on all the factual information that they can assemble. Analytical methods should then be employed based upon the underlying earnings driven rationale that provides the investor reasons to believe that the relationships producing earnings growth will persist in the future. Once we have applied this process and come up with a forecast that we believe to be reasonable, we then need a method to run our numbers out to their logical conclusion.

In short, this means starting with our current earnings yield and then applying our forecast to calculate future earnings yields. The F.A.S.T. Graphs™ research tool offers a simple calculator that runs those calculations which creates a graph, followed by a table that can be scrutinized and analyzed.

Additionally, in order to assess risk, future estimated earnings yields are compared to the riskless guaranteed interest on the 10-year Treasury bond (see discussion on Treasury bonds above). By comparing our expected earnings yield to the riskless yield, we can ascertain whether or not an investment in the company's stock offers the potential to compensate us for the risk we are assuming.

Earnings Yield - The Inverse of the PE Ratio

At this point, and for clarification purposes, a few words about earnings yield are necessary. The calculation for earnings yield is simply the inverse of the PE ratio, which we express as the EP ratio. More simply stated, the company's earnings are divided by the stock price to determine the earnings yield. In essence, this tells us how much return per share the company's earnings per share represent given the price we are paying to buy those earnings. Just like any other yield, the higher the earnings yield the better the return and the greater the potential mitigation of risk. Ideally, investors should be, at a minimum, looking for an earnings yield that is greater than the yield offered by a riskless investment like a Treasury bond. Otherwise, why take the risk of owning a stock in the first place?

An Explanation of Valuation by the Numbers and In Pictures

Since a picture is worth 1000 words, we will utilize the F.A.S.T. Graphs™ research tool's Estimated Earnings and Return Calculator™ in conjunction with the EYE™ (earnings yield estimator) chart to hopefully crystallize the true meaning behind valuation. At their core, these graphs and charts take mundane numbers and formulas and express them into an instantly comprehensible pictorial depiction of valuation.

Although this is a very efficient method of recognizing valuation, we believe it's critically important that the reviewer understands the mathematical principles behind what is being expressed with these pictures. What follows will be a dissertation on interpreting the graphs and charts while simultaneously elaborating on the important prudent principles of valuation they represent.

Given that this is an intellectual exercise designed to explain the principles behind intrinsic value utilizing the PE ratio, we are going to ask the reader to assume that they agree with the estimates that will be used when evaluating Amazon.com Inc. (AMZN), our example of overvaluation. In other words, we ask that the reader assume that the process of forecasting earnings described above has been effectively implemented before any of the following graphics were created, keeping in mind that, as previously discussed, the obligation to forecast is required before an intelligent or reasonable opinion of valuation can be ascertained.

In reality, the following forecast of Amazon Inc.com's (AMZN) earnings is based on the consensus of leading analysts' long-term forecasts of earnings growth. In theory at least, these forecasts have been derived after extensive research by these leading experts in their field. However, understand that the graphing tool that is being utilized can be overwritten by inputting any estimate that the user would feel is more appropriate. But also keep in mind that this article is written to illuminate the economic foundation which true valuation measured by the PE ratio is built upon. In future articles we will examine several levels of valuation. However, this article deals with Amazon.com Inc. and the rationale behind our thesis that this growing enterprise is significantly overvalued today.

This article highlights Amazon.com Inc. (AMZN), a pure growth stock, which generally tend to command higher PE ratios, and therefore, simultaneously higher risk. Consequently, the importance of accurate forecasts and sustained growth are critically important with high-growth stocks which typically are also non-dividend payers. In future articles we will look at dividend paying examples where the dividend represents not only a "return on" invested capital, but also a "return of" invested capital.

Amazon.com Inc. (AMZN) - The Earnings Yield Paints a Clear Picture of Overvaluation

The estimated earnings and return calculator on Amazon.com Inc. (AMZN) shows an example of a company where analysts have high expectations for future earnings growth. It's important to note that this first chart looks solely at earnings growth and is devoid of any price bias. The consensus of 27 analysts reporting to Capital IQ forecasts a 5-year earnings growth rate for Amazon.com Inc. at the extraordinary rate of 27.5% per annum (see orange circle at right of the graph).

However, the estimated growth rate is not applied until after fiscal year 2012. The mean consensus estimate for 2011's fiscal year-end is for earnings to fall 55% to $1.14, before recovering to $2.16 in fiscal year 2012 and then followed by the 27.5% 5-year estimated growth rate. These are very high expectations which would generate earnings per share of approximately $5.70 by year-end 2016. However, even this extremely high expectation of future growth does not justify today's lofty valuation as we will clearly illustrate with the final graph in this article.

It should be pointed out and noted, that the higher the expected earnings growth rate the company is expected to achieve, the more difficult, and therefore, the riskier it is to achieve. On the other hand, many consider Amazon to be an excellent company that is capable of achieving this exceptional level of future earnings growth. For arguments sake, let's assume that this is true, which takes us to answering the important question regarding current valuation. Does Amazon's current stock price represent attractive value given these high expectations for growth? In order to answer this important question we need to bring in price and measure the current PE ratio relative to Amazon's growth expectation.

Therefore, we have added weekly closing stock prices to our estimated earnings and return calculator and calculated a current blended PE ratio on Amazon Inc. What we discover is that the current blended PE multiple on Amazon shares calculate to over 156 times earnings. Based on the PEG ratio, a widely accepted valuation formula, Amazon.com Inc. (AMZN) is currently significantly overvalued based on earnings expectations. The dark orange line on the graph represents PEG ratio fair value, and the black stock price line is clearly significantly above this valuation metric.

Using and Interpreting the Earnings Yield Estimates (EYE) Table

Now, let's look at the numbers behind this graphic in order to get a clearer view of how absurdly high Amazon.com Inc.'s shares really are. The following Earnings Yield Estimates™ (EYE) table presents the numbers behind the above estimated earnings and return calculator graphic. Although the pictures above are clearly worth 1000 words, evaluating the numbers behind those pictures can really crystallize the significance behind the pictures. Stated as simply as possible; when the price line becomes disconnected from the valuation line, the numbers simply do not add up. The Earnings Yield Estimates™ (EYE) table lays out the pictures in their numerical form. However, in order to receive the maximum benefit when reviewing them, a few words about their design are in order.

First and foremost, the EYE table (below) calculates forward earnings out 10 years based on the consensus estimated growth rate. From this point of view, it is merely a calculator acting much like any spreadsheet acts. Whether or not Amazon.com Inc., or any company, is incapable of achieving this level of growth for that long a time frame or not, is not what is being questioned. Instead, we're simply pointing out that even if Amazon is successful, that running these numbers out to their logical conclusions simply do not add up. Remember, for illustration purposes, we are assuming that the analysts' estimates are correct.

Therefore, let's analyze what the results would look like and mean if Amazon does achieve these lofty goals through the lens of the F.A.S.T. Graphs™ EYE calculator. The first eight columns on the EYE table deal specifically with Amazon.com Inc.'s earnings and dividends to include a calculation of potential future returns based on the earnings dynamic underlying them. The final two columns provide a comparison between the potential total cumulative earnings of Amazon.com Inc.'s stock, as compared against the 10-year Treasury bond's fixed interest cash flows.

The EYE table is color-coded to provide the user an instantaneous perspective of valuation levels as they compare to the riskless 10-year Treasury bond. When fair value or undervaluation is present, the columns pertaining to earnings per share are color-coded in green to coincide with the color coding on the historical price and earnings correlated F.A.S.T. Graphs™. Likewise, columns dealing with dividends are color-coded blue. Although the shadings are slightly different (more pastel) than you see on the historical graphs, the primary color schemes are consistent. Since Amazon.com Inc. is a growth stock and pays no dividends, the dividend columns are all pink (light red) and the numbers are all zero.

Additionally, when overvaluation is present the columns are color-coded in pink (light red) to connate warning or danger. Consequently, any time any of the columns are pink, it means that the cumulative level of earnings or dividends are less than the breakeven level compared to owning a Treasury bond. More simply stated; when the columns are pink, the Treasury bond offers higher interest yield than the company's earnings yield or dividend yield.

Furthermore, notice that the starting earnings yield (year 2011) is only .5%, or far below the 2.3% interest yield of the 10-year Treasury bond. And considering that Amazon (AMZN) does not pay any earnings out in dividends, shareholders are relying solely on the capitalization of earnings for their value. This is a clear proxy of the ludicrous nature behind overvaluation. When a riskless Treasury bond is generating five times more cash from riskless interest than the earnings of the company you are measuring, you're obviously not being compensated for the risk you are assuming. This is the essence of the dangers of investing in or owning overvalued stocks.

When looking at the EYE table for Amazon.com Inc. you discover that the cumulative earnings of the company will not exceed the riskless interest paid by the Treasury bond until year number eight. Once again, since Amazon doesn't pay dividends, the dividend column remains pink throughout. The real extent of Amazon's current overvaluation becomes clearly evident when you recognize that total cumulative earnings based on a 27.5% earnings growth rate extrapolated out for 10 years (red circle), which is a very difficult and even unlikely possibility, only barely exceed the total cumulative riskless interest available from the 10-year Treasury bond (green circles). Making matters even worse, is the fact that the 10-year Treasury bond is currently paying interest near a historical all-time low.

Overvaluation is Not a Value Judgment

In the past, we've often written about companies that we believed were being significantly overvalued by the stock market at the time of the writing. Since overvaluation is simultaneously a function of popularity, anything written that was considered negative prompted a strong response. Investors and traders alike, in love with their highflying stock, will have none of it. You would think we were attacking one of their children, or worse. Consequently, it is understandable why overvaluation, more often than not, typically happens to the best of breed companies. People, being the emotional creatures that they are, tend to get upset when you attack their favorite stocks.

But in truth, pointing out overvaluation is not the same as denigrating the value, or in this sense, the quality of the underlying business. Instead, it only refers to the excessive price that the stock market is currently applying. Great management teams behind great companies do have a high level of control over the operating success of the business behind the stock. Amazon clearly has a great management team. However, although great management teams can create intrinsic value, they have no real control over how the market will price their operating achievements. From this perspective, corporate management is at the mercy of the market in the short run. On the other hand, good operating results will achieve their justified valuations over the long term.

Conclusions

Like most of the analysts following Amazon, we believe the company potentially has a bright and prosperous long-term future. Therefore, if we could find Amazon.com Inc. priced at a sensible valuation, we would be very motivated to include it into our growth portfolios. But since we fervently believe in the sage advice that "price is what you pay, value is what you get", we do not believe in investing in even the best of companies when they are being overpriced by the market. When the PE ratio is properly applied as a measuring device, we believe that it will protect the long-term investor from making the obvious mistake of paying too much for even the best company.

Finally, we hope that the reader recognizes that this article was not offered as an in-depth analysis of Amazon.com Inc. (AMZN) the business. Instead, it is offered as a rational look at valuation and the significance and benefit of properly applying the PE ratio when examining valuation. At the end of the day, long-term investors can only invest in the future, and in that context they are buying the future earnings power of the business they are investing in. With this article, we assumed that Amazon.com Inc. (AMZN) was capable of successfully achieving the lofty expectations of the consensus of leading analysts today. Nevertheless, we attempted to clearly illustrate how that growth does not justify today's extreme stock price levels. Caveat Emptor (let the buyer beware).

Disclosure: No positions at the time of writing.