A PE ratio simply means the multiple of earnings the business sold for in the market. For instance, if the earnings are $1 per year and the stock price is $20 right now, the current market PE of the business is 20. That is, the business is selling for a multiple of 20 times its current trailing 12 months of earnings. People don't sell a great business for one year's earnings, a PE of 1. They're going to get those earnings anyway, not to mention the earnings coming in for the decades into the future. People sell great businesses for many times current earnings because they can.
Buyers are happy to pay a number of years of earnings. Its not uncommon for buyers to pay a multiple of 30 for a great business. That 30 multiple or PE means, if earnings don't grow, it would take 30 years to get the money back that they paid. No buyer would be interested in that deal. The reason a buyer will pay a multiple or PE of 30 is that the business is going to grow its earnings. Growing earnings will pay back the original purchase price much faster than 30 years. If the earnings are $1 per share this year and growing at 20%, the earnings will be $1.20 next year, $1.44 the year after, $1.73 the after that and so on. In ten years the earnings will have grown to $6.19 per year and still growing. In 20 years the earnings will be $38.34 per share up from $1 twenty years earlier. (A company that is likely to do that is considered a great company, if you weren't sure.)
If, in the example above, I paid $30 per share for the business and it grew earnings to $36 per share, the earnings would have exceeded my purchase price. And, assuming continued growth, the earnings would continue to do so every year. In other words, at some point the rate of earnings yield will exceed 100% annually. This is why great businesses get PE ratios that are double their expected growth rates - because it pays off in the long run to buy great stuff even if you have to pay more. As Charlie Munger famously said, "Its better to buy a great business at a fair price than a fair business at a great price." That is a statement about PE.
But what about buying this sort of company in a recession. The earnings will be down, the PE will be lower. Shouldn't we lower our projected PE to some recent historical average? No. We want the true, long-term value of the business - the price a buyer will pay in a bull stock market. That's what we should base its current value on, not the market price. All the Rule #1 calculations of value depend on this understanding - we are going to sell in a bull market when Mr. Market is greedy.
The takeaway here is that PE is simply a reflection of earnings growth potential and the more long-term growth potential the higher the PE. Its not a great idea to pay a lot of attention to Mr. Market's short term PE assignments. Long term historical PEs are useful as a check against unwarranted optimism but I basically like 2X the growth rate. Its simple and it works. For more information on why it works, read Chapter 9, "Calculate the Sticker Price" in my first book, Rule #1.
Now go play.
