The last few posts looked at risk — debt, leverage, what could sink a business. Price to earnings switches sides and asks the opposite question: at the price the market is charging, how good is this opportunity?
The idea is simple. Price to earnings compares what a company costs to what it makes. Take a business that earns $1M a year and trades at a market cap of $1M — a P/E of 1. Buy it and a single year of profits returns your money. The other extreme: same $1M of earnings, but a $100M price tag. P/E of 100, and you’re waiting a century to break even. The ratio has to be small enough that the payback fits inside a human lifetime, to say the least.
Different investors draw the line in different places. Warren Buffett has often been quoted preferring P/E around 10 or less. The shortcut for thinking about it is to flip the ratio: 100 divided by the P/E gives you an implied annual return if earnings repeat. P/E 5 implies 20% — roughly what Buffett compounded for seven decades, which is extraordinary. P/E 15 implies about 6.7%. P/E 40 implies betting that the future is going to look very different from the past for that firm.
The hard part is that earnings move around — sometimes a lot. Looking at P/E based only on the last twelve months catches the company at one snapshot, and that snapshot may not represent anything durable. A bad year inflates the ratio. A great year flatters it. Either way you draw a conclusion from a single observation.
This is where Sponda is built differently from most of what’s out there. Alongside the standard trailing P/E, you also get P/E over the last 3, 5, 10 or more years — the same price compared to average earnings over longer windows.
You won’t get this kind of view in many places, and once you have it, going back to a 12-month P/E feels like reading one frame of a film.
That’s price to earnings. More on valuation in the next post.