Tuesday, July 21, 2009

Price Earnings and Payback in Years

Another way to think about the all powderful Price Earnings Ratio is to think of it as Payback in Years. Ok, here's the expraination:

Price Earnings = Price / Earnings

Say if a stock earns 5c per share and you are paying \$1 for it, how many years would it take for you to get back your \$1?

Assuming that it will earn 5c every year forever, the answer is 20 years right?

And how did we get 20 yrs? Well \$1/5c gives you 20.
Which, in case you fail to notice, is the formula for Price Earnings Ratio.

So lower PE means faster payback in years.

Some people talk about it's alright to buy a stock with PE of 40x bcos it's the dream stock, spectacular growth for the next 20 years!

40x is cheap! Let's put in more no.s to this scenario and see what we get:

EPS for 2007 20c
EPS for 2008 40c
EPS for 2009 60c
EPS for 2010 80c

Price in 2009 \$32

This stock is, well... trading at 40x PER for 2010 at \$32. In order to get a decent payback in years (roughly 15 yrs), the stock needs an average EPS of \$2.4 for the next 15 years.

This means that the EPS needs to triple in the next 3 years, grow a bit more and finally stabilize at \$2.6 so that the average can hit \$2.4!

Even if it somehow managed to perform this spectacular feat, what you have paid for at \$32 merely justifies it. You did not get any upside or discount. There is no margin of safety in this investment. So think really hard when you are asked to buy a stock with 40x PER.

Anyways, in line with the points system found in Men are from Mars, Women are from Venus, here is a list of scenarios and the estimated payback years:

Analysed a blue chip for 3 mths & bought it in a bear market - 12 yrs
Analyzed a blue chip for 3 days & bought it in a bull market - 26 yrs
Bought a blue chip without any analysis whatsoever - 33 yrs
Bought a blue chip, heeding advise from a friend - 52 yrs
Bought a blue chip anticipating a RIGHTS ISSUE - 89 yrs

Bought the highest traded stock on SGX after it dipped 10% - 48 yrs
Bought the highest traded stock on SGX after it rose 15% - 60 yrs
Bought a stock that rallied 30% after some good news - 76 yrs
Bought a stock that rallied 30% after some good news, in a bull market - 182 yrs

Bought a stock not covered by any analysts - 27 yrs
Bought a stock rated SELL by an analyst from a broker house - 42 yrs
Bought a stock rated BUY by an analyst from a broker house - 84 yrs
Bought a stock rated Strong Conviction BUY by an analyst from a broker house - 205 yrs

Bought an S-chip at IPO - 51 yrs
Bought an S-chip at IPO, heeding advise from a friend - 90 yrs
Bought an S-chip at IPO, heeding advice from a taxi driver - 122 yrs

Bought a stock Warren Buffett bought, at a lower price - 14 yrs
Bought a stock recommended on this blog - 21 yrs
Bought a stock recommended by a value manager on CNBC - 29 yrs
Bought a stock recommended by a magazine - 48 yrs
Bought a stock recommended by a broker - 128 yrs
Bought a stock recommended by two different brokers - 199 yrs
Bought a stock recommended by a self-professed stock guru, advertising "How To Make 1 Million in 2 week" on Straits Times - 256 yrs

Cheers!

1. So the shortest patback is 12 years correct in your list?:Analysed a blue chip for 3 months & bought it in a bear market - 12 yrs

2. Pls don't take the numbers seriously. They are not meant to be real :)

The basic idea is that you can think of Price Earnings as no. of years you get back your money based on the earnings power of the company you bought.

3. The gag has potential: all you need is more New Age'ish dross.

4. This is really good articles.
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