Investing: P/E Ratio basic question

Question

I'm just starting out in investing so I apologize if this comes across as annoyingly simple question. I've just read about PE Ratio and I came across this video from investopedia P/E Ratio Video which I thought was simplified and was therefore helpful. However, there's this part of the example that I don't get:

At 00:36,

If investment is on Al's, he pays $9 per $1 of earning... If investment is on Bob's, he pays only $3 per $1 of earning.

The idea I don't get is the paying an amount for $1 of earning. I'm not sure why an investor would pay an amount for a dollar earned by the company.

Could anyone be kind to help me clarify this? Thank you!

Answer 1

The idea here is to get an idea of how to value each business and thus normalize how highly prized is each dollar that a company makes. While some companies may make millions and others make billions, how does one put these in proper context? One way is to consider a dollar in earnings for the company. How does a dollar in earnings for Google compare to a dollar for Coca-cola for example? Some companies may be valued much higher than others and this is a way to see that as share price alone can be rather misleading since some companies can have millions of shares outstanding and split the shares to keep the share price in a certain range.

Thus the idea isn't that an investor is paying for a dollar of earnings but rather how is that perceived as some companies may not have earnings and yet still be traded as start-ups and other companies may be running at a loss and thus the P/E isn't even meaningful in this case.

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Assuming everything but the P/E is the same, the lower P/E would represent a greater value in a sense, yes. However, earnings growth rate can account for higher P/Es for some companies as if a company is expected to grow at 40% for a few years it may have a higher P/E than a company growing earnings at 5% for example.

Answer 2

Let's take a step back. My fictional company 'A' is a solid, old, established company. It's in consumer staples, so people buy the products in good times and bad. It has a dividend of $1/yr. Only knowing this, you have to decide how much you would be willing to pay for one share. You might decide that $20 is fair. Why? Because that's a 5% return on your money, 1/20 = 5%, and given the current rates, you're happy for a 5% dividend. But this company doesn't give out all its earnings as a dividend. It really earns $1.50, so the P/E you are willing to pay is 20/1.5 or 13.3. Many companies offer no dividend, but of course they still might have earnings, and the P/E is one metric that used to judge whether one wishes to buy a stock. A high P/E implies the buyers think the stock will have future growth, and they are wiling to pay more today to hold it. A low P/E might be a sign the company is solid, but not growing, if such a thing is possible.

Answer 3

While on the surface it might not make sense to pay more than one dollar to get just one dollar back, the key thing is that a good company's earnings are recurring each year.

So, you wouldn't just be paying for the $1 dollar of earnings per share this year, but for the entire future stream of earnings per share, every year, in perpetuity -- and the earnings may grow over time too (if it remains a good company.)

Your stock is a claim on a portion of the company's future. The brighter and/or more certain that future, the more investors are willing to pay for each recurring dollar of earnings.

And the P/E ratio tells you, in effect, how many years it might take for your investment to earn back what you paid – assuming earnings remain the same. But you would hope the earnings would grow, too. When a company's earnings are widely expected to grow, the P/E for the stock is often higher than average.

Bear in mind you don't actually receive the company's earnings, since management often decides to reinvest all or a portion of it to grow the company. Yet, many companies do pay a portion of earnings out as dividends. Dividends are money in your pocket each year.