If you recall from Part 1, I mentioned that one way of looking at the P/E ratio is to consider it as the price today of purchasing a $1 income stream for life. When people bid up a stock, and hence the P/E ratio, they are basically saying that they believe that company’s future earnings outlook are more promising, and are willing to pay more to own a piece of those future earnings.
So What’s A Fair Price For A Company?
Let’s assume we have a company that is guaranteed to provide $1 per year for life no matter what (i.e. there is no business risk whatsoever – purely wishful thinking!). In this case, what would be a fair price to purchase that income stream? Well, if we assume that we are going to live for another 80 years, then you might say $80 as a starting point because 80 years times $1 = $80. You would think, I’m going to get $80 over the next 80 years – therefore this is the fair price. Right?
Wrong.
The Present Value of a Dollar From the Future
You are essentially giving up $80 now in a lump sum today in exchange for getting eighty $1 dollar payments over 80 years which is crazy when you think that you could just get a high interest savings account and get 3% interest on your $80 lump sum starting today. In fact, the first year’s interest alone would be $2.40 – that’s much more than $1. And after 80 years, your original $80 dollars would’ve grown to $826.48, if you kept re-investing the interest.
Let’s start by figuring out what a better price would be to pay for $1 that will be received in the future, starting with next year. Basically, we need to start by asking: What do I need to invest at 3% today, to get $1.00 in one year?
In this case, the answer is $0.97 (rounded). In other words, to have $1.00 NEXT year, you would need to invest 97 cents into that 3% high interest savings account. Therefore, you might pay $1 for this year’s $1 income from the company, but you would definitely not want to pay more than $0.97 for next year’s $1.
Let’s move to year 3. What would you need to invest TODAY at 3%, in order to get $1 in 2 years? The answer is $0.94 (again, rounded for simplicity’s sake). $0.94 invested for one year at 3% equals roughly $0.97, which when invested for the second year at 3% will give you $1.
So you can see, the further out that company’s $1 annual income is, the less you would want to pay for it. If we fast forward to year 80, you would only need to invest 9 cents today in order to have $1 eighty years from now.
Below, I have charted the present value of $1 for every year between now and 80 years from now, based on a 3% interest rate. If we add up all of those values, we then have $30.20. Therefore, assuming there is no business risk, and we are guaranteed an earnings of $1.00 per share every year for the next 80 years, $30.20 per share is a much fairer price than $80.00 to pay for this income stream. (If you can’t see the graph, click here.)
Still Not Done!
We are not quite yet done with the discussion. There are two more things we need to factor in. 1) Investors expect to be compensated for the risk they take in making an investment that is more risky than a high interest savings account (this would bring the price that they are willing to pay DOWN), and 2) the price goes up if the company’s earnings are expected to increase. We’ll cover these off in the next post and then we will wrap up with a fourth post that explains some real world applications (I had originally thought I could do it in three posts, but I wanted to be thorough).
Very nicely put.