[/caption]
Another way to think about the all powderful Price Earnings Ratio is to think of it as Payback in Years. Ok, here's the expraination:
Price Earnings = Price / Earnings
Say if a stock earns 5c per share and you are paying $1 for it, how many years would it take for you to get back your $1?
Assuming that it will earn 5c every year forever, the answer is 20 years right?
And how did we get 20 yrs? Well $1/5c gives you 20.
Which, in case you fail to notice, is the formula for Price Earnings Ratio.
So lower PE means faster payback in years.
Some people talk about it's alright to buy a stock with PE of 40x bcos it's the dream stock, spectacular growth for the next 20 years!
40x is cheap! Let's put in more no.s to this scenario and see what we get:
EPS for 2007 20c
EPS for 2008 40c
EPS for 2009 60c
EPS for 2010 80c
Price in 2009 $32
This stock is, well... trading at 40x PER for 2010 at $32. In order to get a decent payback in years (roughly 15 yrs), the stock needs an average EPS of $2.4 for the next 15 years.
This means that the EPS needs to triple in the next 3 years, grow a bit more and finally stabilize at $2.6 so that the average can hit $2.4!
Even if it somehow managed to perform this spectacular feat, what you have paid for at $32 merely justifies it. You did not get any upside or discount. There is no margin of safety in this investment. So think really hard when you are asked to buy a stock with 40x PER.
Anyways, in line with the points system found in Men are from Mars, Women are from Venus, here is a list of scenarios and the estimated payback years: Read more...[caption id="attachment_3020" align="alignright" width="150" caption="Photo by Kyle May"][/caption]
Another way to think about the all powderful Price Earnings Ratio is to think of it as Payback in Years. Ok, here's the expraination:
Price Earnings = Price / Earnings
Say if a stock earns 5c per share and you are paying $1 for it, how many years would it take for you to get back your $1?
Assuming that it will earn 5c every year forever, the answer is 20 years right?
And how did we get 20 yrs? Well $1/5c gives you 20.
Which, in case you fail to notice, is the formula for Price Earnings Ratio.
So lower PE means faster payback in years.
Some people talk about it's alright to buy a stock with PE of 40x bcos it's the dream stock, spectacular growth for the next 20 years!
40x is cheap! Let's put in more no.s to this scenario and see what we get:
EPS for 2007 20c
EPS for 2008 40c
EPS for 2009 60c
EPS for 2010 80c
Price in 2009 $32
This stock is, well... trading at 40x PER for 2010 at $32. In order to get a decent payback in years (roughly 15 yrs), the stock needs an average EPS of $2.4 for the next 15 years.
This means that the EPS needs to triple in the next 3 years, grow a bit more and finally stabilize at $2.6 so that the average can hit $2.4!
Even if it somehow managed to perform this spectacular feat, what you have paid for at $32 merely justifies it. You did not get any upside or discount. There is no margin of safety in this investment. So think really hard when you are asked to buy a stock with 40x PER.
Anyways, in line with the points system found in Men are from Mars, Women are from Venus, here is a list of scenarios and the estimated payback years: Read more...
[/caption]
Another way to think about the all powderful Price Earnings Ratio is to think of it as Payback in Years. Ok, here's the expraination:
Price Earnings = Price / Earnings
Say if a stock earns 5c per share and you are paying $1 for it, how many years would it take for you to get back your $1?
Assuming that it will earn 5c every year forever, the answer is 20 years right?
And how did we get 20 yrs? Well $1/5c gives you 20.
Which, in case you fail to notice, is the formula for Price Earnings Ratio.
So lower PE means faster payback in years.
Some people talk about it's alright to buy a stock with PE of 40x bcos it's the dream stock, spectacular growth for the next 20 years!
40x is cheap! Let's put in more no.s to this scenario and see what we get:
EPS for 2007 20c
EPS for 2008 40c
EPS for 2009 60c
EPS for 2010 80c
Price in 2009 $32
This stock is, well... trading at 40x PER for 2010 at $32. In order to get a decent payback in years (roughly 15 yrs), the stock needs an average EPS of $2.4 for the next 15 years.
This means that the EPS needs to triple in the next 3 years, grow a bit more and finally stabilize at $2.6 so that the average can hit $2.4!
Even if it somehow managed to perform this spectacular feat, what you have paid for at $32 merely justifies it. You did not get any upside or discount. There is no margin of safety in this investment. So think really hard when you are asked to buy a stock with 40x PER.
Anyways, in line with the points system found in Men are from Mars, Women are from Venus, here is a list of scenarios and the estimated payback years: Read more...
