One of the best known ratios for stocks is the price-earnings (PE) ratio, it's used to indicate the multiple that the market puts on a company's earnings based on its prospects and how its industry is valued. Simply dividing the share price of a stock by its earnings per share gives you that multiple, but is a fast growing company with a PE of 40 too high? Or is a slower long-term earner like a real estate investment trust a better buy at a PE of 11?
Earnings return and growth
The first way to look at this ratio is upside down, the E over the P, which like a business opportunity says that if I buy a share of SEEK Limited (ASX: SEK) at $16.14, I am buying it at 40.9 cents per share earnings. For my purchase, I am getting a 2.53% earnings return, which doesn't sound too attractive, but let's go along with it for now.
Just for a quick reference, a PE of 10 means a 10% earnings return and a 50 would be 2%.
The Equity/Bond
Warren Buffett, the chairman of Berkshire Hathaway Inc (NYSE: BRK.A, BRK.B) and one of the world's richest people, encourages investors to look at stocks at "equity/bonds", in that based on the price you buy at, the earnings return is similar to payments of a bond over time. Seek's shares pay a 2.53% return as a "bond".
Yet different from a bond, what if the return grows each year? That would explain Seek's popularity among investors who look past the low immediate earnings return, and ogle the growth in earnings. Earnings per share since 2005 have grown almost seven times from the 6.9 cents per share it got eight years ago. Calculating a compound annual rate, it comes out to be 24.9% on the average in earnings growth.
Returns and earnings growth
So as an equity/bond, would you like to have a bond with a 2.53% return and that return grow 24.9% each year? I can't say that the company will repeat its past eight-year run of earnings growth and frankly no one else can. It could slump next year, or business conditions could change enough to bring the growth down to levels of mature companies like Wesfarmers Ltd (ASX: WES).
The high PE ratio is based on above average earnings growth and that's why high PE stocks get punished severely for slipping just a bit, because the earnings gravy train might not be as sure as one would like to think and shareholders bail out quickly.
Foolish takeaway
That's why it's a surer return on your investment to seek lower PEs and higher earnings returns. A company with solid long-term earnings growth history will have a better chance at maintaining a certain level of growth, although everything reverts to the mean over time.
