PHIL TOWN

Phil Town on PE Ratios - Stick to What You Learned in Rule #1

Phil Town gave a previous post here that was a response to one reader's question. 

But let's not get too enthusiastic about PE.  We don't care what the PE is.  Really.  I don't really even look at it when I'm looking at a company. 

The reason the PE is irrelevant is that it doesn't necessarily reflect the true value of the business.  It's an indicator of what Mr. Market thinks, for sure, but then we know Mr. Market is bi-polar and can easily be either depressed or manic about a given company and be completely wrong about the price relative to the value. 

PE is quite a lot like "Dollar Cost Averaging" - brainless.  So stick to what I taught you in Rule #1 about figuring out the value of the business and don't get bothered about PE ratios.

Now go play.

Phil Town

What it Means When PEs and EPS Don't Add Up

Dave recently wrote to Phil Town and asked a good set of questions about PE ratios: 

"Why do some companies have a very high PE and low EPS or a low PE and high EPS? This raises a red flag to me when I see a company like US Steel (X $27.37) with a EPS of $18 and a PE of 1.5?"

Here's what it means:

A PE ratio is the stock price per share divided by the earnings per share.

Businesses are valuable to their owners because of the money they make (the earnings).  When an owner decides to set a price to sell the business, they take into consideration the money they are likely to make in the future if they kept the business. 

If it's a wonderful business (a.k.a. a "Rule #1 company"), the owner is quite certain to make money from the business for many years into the future.  For that reason, no owner of a wonderful business will sell it for just the earnings they were going to make in the next year. 

Owners insist on a price that reflects the certainty of the future earnings -- some multiple of today's earnings.