November 23, 2008

Buy on the Cheap (Price/Earnings) (Session2)

To follow up our Graham intro we will investigate Graham’s first insurance technique of buying on the cheap. Graham used a number of ratios to determine if a company is cheap. The first ratio we need to look at is the Price/Earnings ratio.

What is it?

Market Price per Share
EPS otherwise known as (Total Earnings / Number of shares outstanding)

What does it tell us?

Price to earnings is a ratio that shows us the price you pay to own the current earnings. Think about it like you were buying a company that had net income (total earnings) of 4 Million (4M) dollars per year and had 10 Million shares outstanding. If you bought up all the shares you in effect own the company and have access to that income, if you were to buy just one share though you own a piece of that.
So $4M earnings /10M shares outstanding = 1 share then owns $.40 of the earnings of the company. This is known as earnings per share (EPS), or the bottom half of the P/E equation.
So now that we understand what percentage of the earnings one share owns we can figure out how much it costs us to buy this piece of the earnings.
Let’s say that the company in question has a $10 stock price. So that means that to buy the $.40 in earnings every year you will have to shell out a onetime fee of $10 so if we take the $10/$.40 that gives us a final P/E of 25. So again if you bought the entire company at the listed stock price and put all of the earnings into your pocket it would take you 25 years to get your $10 back.

What does Graham use?

“Current price should not be more than 15 times average earnings of the past three years.”(P.349 The Intelligent Investor)
Graham sets the magic number of <15 as an ideal price to earnings ratio. I would argue that this number is a guide. Some sectors have ridiculously low P/E ratios, others have ridiculously high ratios. It is worthwhile to have a look at sector numbers before getting too excited about a company. Graham builds a case for this also, a point we will deal with later.