Posted on January 8, 2016 @ 10:40:00 AM by Paul Meagher
The price to earnings ratio, or P/E, is a important investment concept.
One reason it is important is because it provides a way to think about how to value the worth of a company. If your company is generating profits then you can use those profits to establish a value for your company. The value of your company is some multiple of those profits. The size of the multiple is the tricky part to figure out.
One factor that determines the size of the multiple is whether you are a private or publicly listed company. The economist Paul
Samuelson calculated that, in a bull market, the multiple for a private company was 3 and a public company was 5. He used gross
revenues as his measure of "earnings" instead of "profits".
Not all revenue streams are created equal. A profit in one industry might be worth more than the same amount of profit in another
industry which would be reflected in higher Price/Earnings ratio in the former industry than the latter. Investors may see more potential for earnings growth in the former industry than the latter.
Yahoo Business publishes an Industry Summary that gives you a rough idea on the P/E for various industries. The "Catalog & Mail Order Houses" industry has an astounding P/E ratio of 955.60 (on Jan 11/2016) which, if you dig deeper, you see mostly reflects the value of Amazon in that industry segment.
The P/E value for different industry segments might tell you something about how to value your revenue stream. Shop around for what might be the best estimate of P/E for your industry. Again, using industry level P/E is only one way to guesstimate what your P/E might be.
My interest in P/E ratios was spurred by reading Marjorie Kelly's analysis of how public companies of the "extractive" type work (see my last blog on Generative Versus Exractive Ownership Design). In particular, I've been studying her systems diagram on some of the main factors influencing profit in a public company and the role that P/E plays.
In this diagram she illustrates how public company Profits can be increased by adjusting the factors in the bottom loop which can be
magnified by the factors in upper loop. If Amazon increases it's profit by 1 million then this gets multiplied by a P/E of 955 which results in a 955 million increase in the valuation of the company. One can see that when Amazon declares a profit it has a bigger effect on company valuation than most companies in the world.
I think it is worth studying Marjorie's diagram for awhile to see if you agree or disagree with her analysis of how Profits in (extractive) public companies are determined - what she calls "the secret of the magic". I also think it is worth studying Marjorie's diagram because it will give you a richer understanding of the P/E ratio by relating it to other economic factors. A definition of the P/E ratio gives you one type of understanding, but seeing how it might work in a systems diagram gives you another type of understanding.
I do want to conclude, however, by pointing out that the P/E ratio is one tool you might use for the purposes of thinking about company valuation.