Price / Earnings: Interpretation #1

6 Apr 2023

In one of my first posts, I talked about the main idea of ​​my investment strategy: buy great “things” during the sales season. This rule can be applied to any object of the material world: real estate, cars, clothes, food and, of course, shares of public companies.

However, a seemingly simple idea requires the ability to understand both the quality of “things” and their value. Suppose we have solved the issue with quality (*).
(*) A very bold assumption, I realize that. However, the following posts will cover this topic in more detail. Be a little patient.

So, we know the signs of a high-quality thing and are able to define it skilfully enough. But what about its cost?
"Easy-peasy!" you will say, "For example, I know that the Mercedes-Benz plant produces high-quality cars, so I should just find out the prices for a certain model in different car dealerships and choose the cheapest one."
"Great plan!" I will say. But what about shares of public companies? Even if you find a fundamentally strong company, how do you know if it is expensive or cheap?

Let's imagine that the company is also a machine. A machine that makes profit. It needs to be fed with resources, things are happening in there, some cogs are turning, and as a result we get earnings. This is its main goal and purpose.
Each machine has its own name, such as Apple or McDonald's. It has its own resources and mechanisms, but it produces one product – earnings.

Now let’s suppose that the capitalization of the company is the value of such a machine. Let's see how much Apple and McDonald's cost today:
Apple - $2.538 trillion
McDonald's - $202.552 billion
We see that Apple is more than 10 times more expensive than McDonald's. But is it really so from an investor's point of view?

The paradox is that we can't say for sure that Apple is 10 times more expensive than McDonald's until we divide each company's value by its earnings. Why exactly? Let's count and it will become clear:
Apple's diluted net income - $99.803 a year
McDonald's diluted net income - $6.177 billion a year

Now read this phrase slowly, and if necessary, several times: “The value is what we pay now. Earnings are what we get all the time”.

To understand how many dollars we need to pay now for the production of 1 dollar of profit a year, we need to divide the value of the company (its capitalization) by its annual profit. We get:
Apple - $25.43
McDonald’s - $32.79

It turns out that in order to get $1 profit a year, for Apple we need to pay $25.43, and for McDonald's - $32.79. Wow!
Currently, I believe that Apple appears cheaper than McDonald's.

To remember this information better, imagine two machines that produce one-dollar bills at the same rate (once a year). In the case of an Apple machine, you pay $25.43 to issue this bill, and in the case of a McDonald’s machine, you pay $32.70. Which one will you choose?

So, if we remove the $ symbol from these numbers, we get the world's most famous financial ratio Price/Earnings or P/E. It shows how much we, as investors, need to pay for the production of 1 unit of annual profit. And pay only once.

There are two formulas for calculating this financial ratio:
1. P/E = Price of 1 share / Diluted EPS
2. P/E = Capitalization / Diluted Net Income

Whatever formula you use, the result will be the same. By the way, I mainly use the Diluted Net Income instead of the regular one in my calculations. So do not be confused if you see a formula with a Net Income – you can calculate it this way as well.

So, in the current publication, I have analyzed one of the interpretations of this financial ratio. But, in fact, there is another interpretation that I really like. It will help you realize which P/E level to choose for yourself. But more on that in the next post. See you!