Slow Grower versus Fast Grower

Rather than focus on price alone, we prefer to use measures of value that relate the price of a stock to some measure of how the company is performing as a business. There are many to choose from, but we recommend two tried and true favorites:

• The price-to-earnings ratio (P/E) and 
• The price-to-sales ratio (P/S).

These ratios measure a stock’s price relative to its earnings or its sales. In the simplest terms, they show a prospective investor how many years’ worth of one share’s earnings (or sales) it would cost to buy a single share of a company’s stock.

Example:

http://spreadsheets.google.com/pub?key=tACdu4SdYelgtyWJpKMMkjQ&output=html

If a stock had a price of $10 and earnings of $1, it would have a P/E of 10. An investor would have to pay 10 years’ worth of a share’s earnings to buy a share of stock in this company. A $10 stock with a P/E of 20 is only earning 50 cents per share, and by this measure, would be twice as expensive as the other $10 stock, since it would cost the investor 20 years’ worth of earnings to buy it.

The lower the P/E, the cheaper the stock - not necessarily in dollar terms, but in terms of this measure of their value. How could such a large difference in value exist?

A P/E ratios are based on the current price and current earnings. (Analysts use either the last year’s earnings or a forecast of next year’s earnings in the calculation.) If a company’s earnings are expected to grow quickly over the years, then this higher expected future earnings stream is considered by buyers to be worth a higher price up-front (i.e. higher P/E).

The table shows the implied future price of two $10 stocks with differing earnings growth rates, assuming they continue to sell at whatever price keeps their P/E ratios unchanged (at 10 for the slower grower, and at 20 for the fast grower). The “expensive” $10 fast grower could look pretty cheap 10 years from now compared to the slow grower, even if it costs twice as much relative to earnings today.

Notice that even though the fast grower’s earnings don’t actually catch up to the slow grower’s earnings until year 15, by then the stock is worth twice as much. The fast growth rate and the expected effect on future prices are driving the price, not the actual level of earnings.

The problem, of course, is that the expected future often has a way of being very different from the future that actually happens. If the lofty expectations priced into a high P/E stock aren’t met, the price tends to take a bigger hit than if expectations were more modest.

One of the advantages of the P/E ratio (or multiple) is that it is very easy to find. Many newspapers publish this number daily, right alongside the price.