P/E ratio, growth, and stock valuation:
Core Idea: Comparing a stock's earnings yield to a bond yield is a starting point, but the crucial difference is growth. Stocks are bought primarily for the potential of rising earnings, not just static income.
The Bond vs. Stock Choice:
A bond offers fixed, predictable income with less risk.
A stock with no earnings growth is inferior to a bond because it carries more risk for the same static return.
A stock with growing earnings is fundamentally different and more valuable.
The Power of Earnings Growth:
If a company's earnings grow (e.g., 10% annually), the earnings "coupon" paid to the shareholder increases each year.
This makes the initial investment far more valuable over time. A $5 initial earnings growing to ~$13 in 10 years would imply a much higher yield on the original cost if the stock price didn't move.
Because the underlying earnings are worth more, the stock price should rise to reflect this future value. Earnings growth is the primary driver of stock price growth.
The Investor's Task (Value Investing Perspective):
Don't just look at the current P/E (or earnings yield). The analysis must focus on:
What the earnings yield is today.
What the earnings yield will be in the future based on reasonable growth expectations.
Conclusion: The P/E ratio alone is static. Its true meaning and the justification for buying a stock instead of a bond depend on assessing the potential for future earnings growth.
