In today’s post I wanted to share with you the results from one of my favorite tools that I developed during my career as a professional money manager. It was a spreadsheet that took me several days to create that analyzed the financial implications of P/E ratios.

Folks bandy about P/E ratios without necessarily understanding what they mean for long-term returns. In case some of you out there do not understand what they are, let me give you a brief overview. The “P” in P/E stands for price. In this instance it is the price paid for a share of stock in a business that you are interested in owning. The “E” stands for earnings, as in the profits that the same business has earned in the most recent calendar year. However, for the P/E to be truly meaningful, the “E” should be the forecasted earnings for the upcoming year. Why? Because as investors we are wanting to capture the future profits of a business. We have no access to the profits that the business earned in the past. That’s why forecasted earnings should be used in the denominator. So why is the P/E ratio constructed in the first place?

• The first concept to understand with the P/E ratio is that a dollar of profits is a dollar of profits no matter what business earned them, yes? Yet, a dollar of earnings costs you, as an investor, different amounts depending on which business you purchase. So the P/E ratio at Google is much higher than the P/E ratio at General Electric. The question is: Why would an investor pay more for a dollar of earnings at Google than they would at General Electric?
• The second P/E concept to understand is that investors are willing to pay more for a dollar of earnings from a business because of the expectation of higher and faster growth rates at a higher P/E business. In other words, you are willing to pay more for Google because you expect that you will end up making a lot more money in an investment in Google than General Electric. Does this make sense?
• OK, so the next concept that I wanted to introduce was the “Earnings Yield.” This is an easy number to calculate. You just flip the P/E ratio upside down and make it the E/P ratio. This is a very, very rough estimate of the yield (similar to an interest rate) that a business is paying. So a P/E of 10.0 has an earnings yield of 1 / 10 or 10%. Whereas a P/E of 40.0 has an earnings yield of 1 / 40 or 2.5%. Does this math make sense to you? So without the expectation of growth in earnings, wouldn’t you be crazy to buy shares of stock in a business whose expected yield to you was only 2.5% when you could own another business that pays you 10.0%?
• The last concept that I wanted to share with you is that of how to relate growth rates to P/E ratios. As demonstrated above, it is absolutely critical to know the expected growth of a business so that you don’t mess up when buying a business, yes? There is a classic, and I do mean classic, Wall Street business valuation short-hand called PEG ratio. So what the heck is that? Well a PEG ratio compares a company’s P/E ratio to its expected growth rate in earnings. So, for example, imagine an imaginary business with an imaginary P/E ratio of 10.0 and an imaginary expected growth rate of 15%. Let’s call this business ABC Inc. So ABC Inc’s PEG ratio is PE / Growth rate, or 10.0 / 15% = 0.66. In this instance, the growth rate is not treated as a percent, but as a whole number; so not 15%, but 15. So is 0.66 a good thing or a bad thing? It’s a good thing. The thinking behind this PEG ratio that is somewhat supported by mathematical calculations, is that a PEG ratio less than 1.0 means a business that is CHEAP. If the PEG ratio is greater than 1.0 then the business is considered EXPENSIVE. However, the most important word in this paragraph is somewhat. But more on that in just a moment.

Digression…you would be surprised how many professional money managers blindly use the PEG ratio in their screens and in their evaluation of businesses. I wish I could give you hard, scientific numbers about the number that use the pure raw, unadulterated PEG, but I cannot. However, it is my estimate that most money managers do not go to the trouble of establishing their own valuation of a business and the appropriate price for stock shares in that business. No, I am not kidding. I recently interviewed with a very well known, highly rated money manager who did not do their own valuations. This is the norm, folks, not the aberration. Those that do their own valuations usually rely on the PEG ratio. So shouldn’t you understand its limitations? That brings us to the subject of today’s post.

You see the first problem with PEG ratios is that they do not factor in what is known as the Time Value of Money. TVM simply means that a dollar in your hand today is worth much more than a dollar in your hand 100 years from now (assuming that 100 years from now the economy is larger than it is now). Doesn’t this make sense? If you were forced to wait 10 years for your bi-weekly paycheck wouldn’t you want more money in 10 years? Of course you would. And what you would want would be interest paid to you, yes? This is all that Time Value of Money means. So PEGs do not include any TVM at all. What this means is that the higher the PEG ratio, the more distorted and WRONG the shorthand valuation method is. For example:

A PEG ratio whose P/E portion is 20.0 requires a growth rate in the earnings of the business 28.6% in order for you to make a 10% return on your investment in a company over a 5 year investment time horizon. Yet the PEG ratio would say that this business is a bargain if the growth rate is just 20.1%! Do you see the distortion?

If the P/E was 30.0 then the growth rate in earnings necessary to earn 10% over 5 years is 44.4%, not 30.1%! You see the higher the P/E ratio, the much higher the growth rate needs to be.

What about for a low P/E ratio, say of 10.0…the math works the same way in the opposite direction. Earnings need only grow 3.5% per year in order for you to make 10%. Why? All of the magic of this is due to compounding. But the problem is that the overwhelming majority of investors, professional and otherwise do not use PEG ratios appropriately.

Now do you see how marketeers (made up word) can “get it so wrong?”

The moral of the story is to be wary of the PEG ratio, especially when the P/E ratio is very, very high.

So the current P/E ratio of the Dow Jones Industrial Average is 10.7 and that of the S&P 500 is about 19.5. Just so you know, the P/E ratios have been over 30.0 for many, many years. I can guarantee you that the U.S. economy was not growing around 30%. No, instead, the U.S. economy was growing around 3-5% for the last several decades. So how could P/E ratios that high be justified given the low growth rates? Well the answer is two-fold. It could have been possible that the businesses that make up the Indexes were growing much faster than the overall economy. This was and is true. However, they were not growing, on average high enough to justify the high P/E ratios!

So the final point of this post is that a correction or reevaluation was absolutely necessary as valuations of U.S. businesses and their stocks was massively over inflated and for a very, very long time.

I hope that all of you out there are happy!

Jason