Businessman Investor

Touching base with the rational business psyche of stock market investors

Friday, September 2, 2011

Squeezing the Rationale Behind the Price/Earnings Ratio... or at least its Twin, the Earnings Yield

I’m not really a fan of the Price/Earnings (P/E) Ratio.Why would you want to divide the stock price by its earnings, anyway? Have we even really thought what kind of information we'll get from that? Or are we using it just because everyone else is. Let’s be honest.

P/E Ratio & Earnings Yield. The P/E Ratio personally doesn't appeal to my reason. Its reciprocal, the Earnings Yield, however, seems to be more logical. It's very reminiscent of the rate of return of a perpetuity annuity!
Well, I’ve been thinking about it... And the immediate, most seemingly logical explanation I can muster (to justify its use) is this: It essentially computes the breakeven period (in years) it would take to recover that stock price you’d be paying assuming the company continues to flatly produce the same earnings. Doesn’t it make sense from this stand point? But why would you want to know that, anyway?

The only way I can think of to make sense of the P/E ratio is by taking its reciprocal—that is, instead of dividing the stock price by its earnings, we do the opposite—divide earnings by the stock price. Thus, we get the Earnings Yield, P/E’s reciprocal twin. I have to admit I had my initial reservations on using this ratio. But after going through several valuation techniques and further pondering on the DCF approach/analysis, the simplistic rationale behind the earnings yield suddenly lit up!

The Earnings Yield as a Conservative Measure of a Prospective Rate of Return

I once blatantly said that: Most seemed to have been misled by the thought that when you buy a stock at Php100 with its most recent reported earnings per share (EPS) being at Php15, you get a 15% rate of return (Php15/100). “Misled” because I thought: Do you even get that return in reality? I was skeptical since I was then focusing on what you immediately possess as a shareholder, which is equity (or book value). That being so, why would you want to compute Earnings/Price? Doesn’t Return on Equity (ROE)—Earnings/Equity—make more sense, so why not just that?

After thoroughly thinking about the implications and logic behind the Discounted Cash Flow model (particularly when I wrote about Intrinsic Value, Bond Valuation, and the Equity Bond Theory—especially that segment on Terminal Value), however, I was slapped on the face by the fact that the earnings yield is somewhat a derivation of the perpetuity formula! perpetui-huh?

Let’s backpedal a little bit so as not to further confuse ourselves. Perpetuities... You see, the clever thing about earnings yield is how reminiscent it is of perpetuities. A perpetuity is an asset which would keep on yielding fixed annual payments up to infinity (yes, forever). Say, a perpetuity investment instrument shall be forever paying Php100 each year; how much would you be paying for that kind of deal to achieve a 15% rate of return? To compute this, the perpetuity equation is:

PV = A/r
PV = Present value or the fair price to pay
A = Annual payments
r = yield or rate of return

Henceforth, to earn a 15% yield from a Php100-paying perpetuity, the fair price to pay is Php666.67 (Php100/15%)—simple as that. In a similar note, but from a different point of view this time, let me ask you: What rate of return do you get from a Php100-paying perpetuity if you pay Php666.67? It’s a related question which has an obvious answer... Correct, 15%! Mathematically, that’s computed as Php100/666.67. So let me repeat just to emphasize: You'll get a 15% rate of return if you pay Php666.67 (i.e. price) for a Php100-paying-a-year (i.e. earnings) perpetuity . Now wait a minute, doesn’t that sound familiar?! It does... it's like the earnings yield!

r = A/PV
Or in English(?):
yield = annual payments / fair price to pay

Let me make that more apparent (in case you miss it): In a perpetuity annuity, when you divide its annual payments by its price, you'll get its rate of return (or its perpetuity yield). Similarly, if we speak of a stock or equity, when we divide its earnings by its price, you'll get its rate of return (or in other words, its earnings yield!). Thus, we can now argue that the earnings yield (which is akin to the perpetuity yield) is a conservative return measure useful to quickly assess what rate of return we can expect if, and only if, we are long for the stock. Further, the perpetual assumption seems reasonable enough given we’re talking about excellent businesses which are going-concerns with lifespans that are indefinite (as long as they keep on raking up profits). I emphasize that it is a conservative measure because while it assumes infinite earnings projected beyond, they are, nonetheless, still flat forever (and that's also not counting its Cash Hoard, should it have any).

On the downside, it’s not so much of a catch-all-scenarios formula because it will only make sense if, and only if again, the company’s earnings parallels its free cash flow (remember, Cash is King)—that is to say, it’s so profitably liquid its net income can already be likened to cash profits! Furthermore, while, it doesn’t give justice to high growth companies which can expand its earnings at high rates, it’s safest still to assume flat or zero growth just to be on the safe, conservative side.

So say, Stock XYZ, an excellent business, has Php758 in EPS. If you want to achieve a 15% rate of return, you can conservatively get a fair price to pay by assuming its earnings will be flat and by computing: Php758/15% = Php5,053. Thus, Php5,053 is a safe (even a bargain) price to pay.

So just keep in mind, when you are being seduced by that oh so popular and sexy P/E ratio, just go see her reciprocal and more business-sensible twin, Ms. Earnings Yield. And the next time you hear someone say that Stock ABC's P/E is currently 15, then that just means that, zero growth earnings-wise (or in perpetuity annuity terms), its yield is conservatively 6.67% (100/15). At least the P/E buzzword now has a lot more business-sense in it worthy of a savvy, return-conscious investor, eh?

An aside: Since I want my money to yield 15%, the counterpart P/E ratio for that would be (100/15) 6.67. You can go derive your P/E ratio counterpart for your own required/preferred rate of return so as to quickly make use of readily available (and often published) P/E ratios.

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The information presented here is for educational purposes only. Under no circumstances should it be construed as a recommendation to buy, sell, or hold any stocks. If you choose to use this information, you do so at your own risk.

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