## Evolutionary gene, psychology & investment

In the next 10 minutes, you will clearly understand if the P/E ratio is meaningful or not. Most readers may be familiar with the P/E ratio. Some may think that low P/E means you are buying it cheap. But for many others, it’s a new word. How do we find out the P/E ratio? What does it mean?

Price-to-earning ratio ( P/E) =   Share price/ Earning per share

Using (Market capitalization/Net earnings) may give the same results most times except when new capital is issued. Let’s stay out of the woods and use the market cap for simplicity.

### Net worth of banker and teacher

I was trying to explain to my 10-year-old son using an example. In our example, the banker was earning 200K and the teacher was earning 100K each year. I told him that he has an option to claim the net worth of either banker or teacher after 10 years. To keep it simple, their earning does not change and both will stop working after 10 years. He immediately picked banker.

I asked him what happens if the banker spends 190K to maintain his lifestyle. The banker will have 10K is left each year. On the other hand, the teacher maintains his lifestyle by spending 80K. The teacher will have 20K left each year. He could clearly see that the teacher will have 10 x 20K = 200K net worth after 10 years. The banker will have 10 x 10K = 100K net worth.  He changed his answer and said he would like to claim the net worth of the teacher.

### Value of a company

Companies are not different. Worth of a company is the total cash we can take out of business during entire life of the business. Imagine you inherited 100M from a rich uncle. You are interested to buy either the oil company or the funeral home. Both businesses are available to you at 100M.

We can ignore the inflation here for simplicity and assume that businesses will be alive for generations. An oil company is generating 20M earnings each year. Oil company needs to put 19M out of 20M back into the business to keep it running at the same level. 1M is left each year for owner to take out.

The funeral home is generating 10M earninngs each year. The funeral home needs to put 5M out of 10M back into the business to keep it running at the same level. 5M is left each year for owner to take out.

P/E of oil company : (Price of oil company)/(Earnings of oil company) = 100M/20M = 5

P/E of funeral home : (Price of funeral home)/(Earnings of funeral home) = 100M/10M = 10

Should you spend 100M to buy oil company due to having a lower p/e? An owner can take out 5M each year out of the funeral home, but only 1M from the oil company. Owning the funeral home a much better  despite having a higher P/E ratio. It’s clear that the p/e ratio is meanigless. Earnings does not matter. What matters is the cash left in the business which can be taken out by owner without impacting the business.

### P/E is meaningless for valuation

Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business.

Warren Buffett ( 2000 annual report)

We saw that a business having P/E of 10 was cheaper than another business having P/E of 5. Even though P/E ratio is quoted often, we can safely ignore it. IRS will be very interested in finding out the earning figures of the banker, teacher, oil company, and funeral home. IRS wants to tax earnings and it’s very important for IRS, but it’s not important for an investor.

I wouldn’t look at a single valuation metric like relative P/E ratio. I don’t think price-to-earnings, price-to-book or price-to-sales ratios tell you very much.

Warren Buffett ( BRK annual meeting 2002)

As an owner of a business, you lay out cash and hope to get back more cash over time from the business. P/E does not help you figure that out. Its widely available and often quoted in media, but useless when doing valuation.

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E-mail : Rohit  @  ChainStreet.com