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Investing

What Is A Good PE?

The Price-to-Earnings ratio (PE) that you are willing to pay for a company should depend on three things: the growth rate of the company, the time frame of your investment and your expected return.

If you are happy with 5% annual return on investment (ROI), assuming either the company pays out 100% of it’s earnings in dividends, or you perceive the value to be retained in the company to be part of your return, a PE of 20 is what you should strive for (5% being the whole company divided into 20, or 100 / 20 = 5).

If a company has zero growth and this is always true, a PE of 20 will eternally get you your 5% ROI. But if the company is growing, and you pay a PE of 20, then each year the PE will improve on the former year (inflation excluded). This is where the other part of my statement comes into play, whereby the growth rate and time frame of your investment will effect the PE you need to pay to get a PE of 20 within your given time frame.

In other words, if you are happy with a PE of 20, but don’t mind waiting a year for the price you paid to become a PE of 20 after a few years growth, you would be willing to pay a PE of greater than 20 to get a better return in years to come.

For example, if you pay $100 for a share of a company that has $4 worth of Earnings Per Share (EPS), you’ve paid a PE of 25 (100 / 4 = 25). If that company grows EPS to $5, you effectively paid a PE of 20 (100 / 5 = 20). If you’re investment time frame is a few years, you might be happy to wait for the PE to take a year to get to an acceptable level, especially knowing that years after, with more growth, your effective PE would be much less than 20.

Here are 3 graphs I’ve created showing how PE changes over time based on an initial purchase at a specific PE for companies with different annual growth rates. The different graphs show how a higher purchase price extends the time frame for the investment to become acceptable.

This should help calculate a good PE to buy shares at, based on your expected ROI, time frame and the growth rate of the company.

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Investing

Calculating PE, My Proprietary Method

I would like to share my proprietary method for calculating Price to Earnings (PE) ratio. I’m happy to share this IP with you, you are free to use it as you wish or discard it.

The reason I created this method of calculating PE is because I wanted a metric that I could use to calculate how much value there was in a business. For me, a traditional PE calculation doesn’t consider the total amount of money that you could get for your investment because dividends are removed from the earnings calculation and it doesn’t consider how much equity (in cash and cash alternatives) that a company could use to pay out to it’s shareholders. This is my proprietary PE calculation:

(Market Capitalization – (cash + cash alternatives)) / NPAT

Lewis Hurst

This equation effectively gives you the part of the business your buying divided by the amount of money you could potentially receive.

Why Remove Cash And Cash Alternatives From the MC?

If a company’s Market Capitalization (MC) is $100M and the company has $99M in the bank, if you bought the business you’d own the $99M in the bank. Effectively the business cost only $1M, which is why I think it’s a more reasonable value to use than the MC alone.

The equation doesn’t add debt to the MC because even though you inherit the debt when you buy a company, you could view the interest as an expense like any other, which is taken into consideration by the NPAT.

Why Divide By NPAT?

I like to divide by NPAT instead of Net Income – Dividends, because NPAT is the amount of money that could come out of the company and go straight into your pocket. It’s the reason to invest and the value that’s generated by the company, as I see it. I don’t use figures before tax because I don’t consider how much I can help the tax man as part of my investment rationale when building a case about whether an investment is worthwhile.

I suppose you could call this an APNPAT (Adjusted Price to NPAT) ratio, instead of a PE ratio. As usual, different companies have different structures, risks and growth rates, which effects what metrics you might consider using in your investment proposition. Another factor is obviously your exit strategy. I probably wouldn’t use such a metric for an investment where the exit strategy was a sale, a traditional PE would be better in this case. However, if I were buying for dividend growth, I find this metric better.

I’d love to hear your constructive feedback in the comments below, and also any of your own valuation calculations that you’d like to share.

Categories
Investing

How To Calculate PE

PE, or Price to Earnings ratio is a measure of a company’s price, relative to it’s earnings. It can either be measured as a forward looking metric or a backwards looking metric.

To calculate the PE of a company, you divide it’s Market Capitalization (MC) by it’s earnings, or Net Income – Dividends. To calculate the forward PE, you use projected earnings (forecast by you or the company); to calculate the backwards PE, you use the earnings from the most recent financial report.

PE is a sort of valuation method to see if a company is worth investing in at it’s current price. You can think of the PE as the number of years you’d have to own a share in the company before the company earned enough money to cover the cost if your purchase (assuming earnings are the same each year).

For example, if a company’s MC is $100M and it’s earnings are $10M, the PE would be 10 (100 / 10 = 10). After 10 years of earning $10M, the company would have made $100M (excluding amortization & interest on the value of the money).

Assuming all this money is paid out in dividends, the investor would have made their money back. In this scenario, a PE of 10 might be considered as a 10% ROI.

Depending on several factors, such as risk, market sentiment, the growth rate of a company and expected return, an investor might be willing to buy a company at a higher or lower PE.

A fair PE for a company with zero annual growth might be 11, while a company growing at a fast rate might command a higher PE, such as 25 – 40. The PE that you are willing to accept is directly related to the amount of return you want to achieve on your investment – it is this factor that brings market sentiment into the equation.

It’s worth considering that this method of calculating value in a stock price doesn’t consider growth of a company sourced from investing profits back into the company before realizing them on a balance sheet, which is a tax efficient way to grow the company. PE is more suited to valuing mature companies, or growth companies with a significant profit margin. PE also doesn’t show value in a company that is not profitable.

This method is a provides a very real perspective of the Return On Investment (ROI) because it considers the part of the profits that are held by the company – though it’s important to ensure that if those profits which were held back are reinvested, that they do actually translate into growth. Otherwise they are just a poorly reported costs of doing business.

Finally, please feel free to check out my own proprietary method for calculating PE.