"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.
Public businesses are far easier to sell and much more transparent in their accounting and business practices, and therefore buyers are willing to give a higher multiple of current earnings. There is a huge range, of course. One of the highest I ever saw for a business with positive earnings was Yahoo!, which traded at a PE of over 11,000.
That is an astonishing number when you consider that the PE ratio is the number of years it will take to pay off your investment if the earnings don't grow. (The idea is that each year's earnings go in your pocket, and in only 11,000 years you have your money back if you bought Yahoo at that price.)
This is an extreme example, but it points out that earnings GROWTH is a key issue in a buyer's mind when it comes time to decide what to pay for a business.
It works the other way, too. If a business is expected to see its earnings decline over the next ten years, buyers aren't going to be willing to pay a high multiple of current earnings because the total of expected earnings over the next ten years might add up to only 5 times this year's earnings.This is likely the case with US Steel at the time Dave was looking at it. If earnings are expected to decline or even go negative, or if labor is expected to strike and stop the business for a year or two, or if an Indian steel company is taking over the industry and putting US Steel into danger of bankruptcy, no buyer is going to want to pay much for the business.
Buyers who are interested in this kind of situation might be looking at the balance sheet of the business to see if they can buy it and break it up into pieces and sell it off. You've heard of guys like Carl Icahn doing that with businesses like TWA. It's not, as you can imagine, real popular with the employees, but sometimes that's the way for the owners to get the maximum price of a business that's worth more dead than alive.
Dave is right to take some comfort from a 19 PE at RIMM. That PE is saying smart people think this thing is going to be around to make money in the future.
US Steel's PE of 1.5 is telling us that some smart people think it's headed for the graveyard. (Of course the fact that other smart people are taking that bet and buying at a PE of 1.5 tells you that markets are made by people who fundamentally disagree on the future value of the investment.)
Which leads me to my point: You better know your business.
If you buy US Steel with a 1.5 PE, you better have a good reason. But you also need a good reason to buy RIMM at at a 19 PE. Maybe even a better reason. You can lose a lot of money buying a business with a high PE. If things don't work out you'll see that PE ratio drop like a brick and take your investment with it.
And that's why I don't value a business entirely on PE and growth rates. In Phil Town's new book, Payback Time (Random House, Feb 2010), I'll teach you how we decide the price to pay when we buy private companies and we'll apply that technique to stocks to protect us from overpaying.Now go play.
