The best way to think about the P/E ratio: You must understand that you're buying a business when you buy a stock. Here is a real-life example to drive the point home.
Several years ago, a friend and I considered buying a sporting goods store. It was a family-run business, with virtually no debt -- or cash -- on the balance sheet. The owner wanted $100,000 for it.
What's the most important thing you'd want to know if you'd been in our situation? Right: how much money we could reasonably expect to earn over the next few years. We didn't care about the fiction of accounting earnings (point No. 1) -- we wanted to know how much in real cash profits the business could pull in.
If it were $10,000 per year, we'd be getting the company at a P/E of 10 ($100,000 / $10,000 = 10). If it were $5,000, that's a much less attractive multiple of 20.
We dived into the fundamental analysis to figure out the real earning power of the company (point No. 2). The short story is, we thought we could make the business much more efficient (improving the margins), but future revenue and earnings growth (point No. 3) seemed very limited due to several well-financed competitors in the area.
In assessing whether this was a smart purchase, we used the three points to come up with our decision. In the end, we passed on the purchase because the P/E we calculated was over 20. Using that number hand-in-hand with our analysis, we knew it would have taken too long for us to even recoup our original investment. But the exercise itself was a lesson I'll never forget.
When buying a small business:
Point 1: Past accounting earnings are a guide, but can be manipulated. More importantly is to conservatively assess the real earning power or cash profits of this company over the next few years.
Point 2: Can you increase this real earning power through improving its efficiency - the profit margins?
Point 3: Assess its future revenue growth and earnings growth. Are these sustainable?
Having assessed the quality of the business and its management, the other decisions one has to make are:
Point 4: Would you like to own or run the business of this company?
- If the answer is no, walk away.
- If the answer is yes, proceed on to next step.
Point 5: Is the seller's price attractive for you to own this company? Given your target of a certain return on your investment, what is the 'maximum' price (akin to intrinsic value) you are willing to pay to own this company?
Point 6: Can you buy this company at a discount to your price? Ask for a discount from the seller? Maybe 'wait' for a discount from the seller? Also remember, it is also alright to buy at a fair price, especially if it is a good business with good fundamentals, up for sale for various reasons.
Essentially, this is not dissimilar to our use of QVM method in assessing which companys' stocks to invest in. (Q=Quality, V=Value, M=Management)