ShmoopTube

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Finance a lash up What is the price to earnings

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ratio All right You just inherited a thousand shares of

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whatever dot com which trades publicly for twenty bucks a

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share And you also inherited a thousand shares of pepsi

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And that stock trades publicly for forty bucks a share

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Your sister got the pewter bunny rabbit collection but well

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you can live with that fact that you take the

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thousand shares All right so what on earth do you

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do now What do you do with these things Well

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you have no idea Because you're an orthodontist and you

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have your hands in wet mouths all day Well if

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you'd inherited a truckload of floss well then we totally

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know what to do with it All right Will you

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check out the brokerage reports from morgan stanley on whatever

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dot com it has one hundred million dollars in revenue

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and no earnings no profits Well what Our earnings again

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Oh yeah This revenues from whatever's app sales at a

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buck Each one hundred million of them minus its cost

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of goods sold Well it had to pay fifty million

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bucks to apple and others to get it saps out

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There well then it had a small army of engineers

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and product people on payroll to build The app will

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subtract another thirty million box then it had rent in

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legal expenses and health care insurance and office things like

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computers and app servers All of that added up to

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be twenty million dollars and because of the accounting laws

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you have to subtract it all last year Even though

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the app it lasts a long time i had to

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take it all off the top It had a hundred

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million dollars in revenues and a hundred million dollars in

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expenses and no earnings but it has fifty million shares

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outstanding which when multiplied by twenty bucks a share that's

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What the market's paying for it twenty dollars share It

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gives it a market value of a billion bucks Take

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the shares outstanding kinds of market price to get what

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the company's worth at least according to wall street buying

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and selling the shares Oh it has fifty million dollars

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in cash on the books and no debt so the

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market is valuing the equity of the company at nine

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hundred fifty million dollars meaning it's valuing the earnings power

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Of the company in the future in his hands at

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nine Fifty alright so you wonder forth an honest and

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would be flossed cellar that you are How khun something

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with no profits no earnings be worth a billion dollars

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Well you read through the report which notes that the

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revenues are growing really fast like one hundred percent a

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year and that the market whoever that is believes that

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the company will have two hundred million in revenues next

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year and for hundred million the following year and on

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four hundred million of revenues it will have one hundred

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million dollars in net earnings It'll also produce fifty million

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in cash along the way so in two years it

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will have one hundred million dollars in cash on the

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books and no debt If you go back and think

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about that that you could subtract one hundred million from

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the billion and it's the nine hundred million of equity

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value back we'll get All right So you ponder that

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means that today at a billion dollars i'm paying if

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i buy it at twenty bucks a share i'm paying

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nine times the earnings expected in two years Two years

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From now for the equity value of this company huh

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Well is nine times earnings cheap expensive Attaway frame the

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notion Well the average snp company trades it about sixteen

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times two years out earning something like that But the

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average company is totally different from whatever dot com The

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average company is like a caterpillar Tractors or well pepsi's

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kind of average Wells fargo kind of average Well it's

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a mature company unlike whatever dot com and the people

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who write for shmoop but not mature way No Well

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caterpillar has been around for a century has a stable

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set of fires And you know what are the odds

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People still need tractors to mine food in five years

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You have pretty good odds whereas whatever dot com might

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have totally evaporated by them Yeah well what about revenue

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growth Yep Caterpillars matured gross revenues that only about eight

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percent a year in a good year And it has

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a lot of capital expenses Well every decade or so

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it needs a new smelting plant to smelt engines and

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redo its manufacturing process Tio you know keep up with

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the joneses or rather the blues or chains Oh and

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it pays a small dividend yeah helps well tough company

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to compare with whatever dot com but caterpillar trades at

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about sixteen times thiss years earnings and it'll grow earning

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slowly and you note that it trades at fifteen times

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and extras projected earnings and fourteen times the following year's

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earnings So that's interesting caterpillar trades at a hire multiple

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on two year forward earnings than whatever dot com who

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does that make sense It's nowhere near ist sexy a

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company but it must be the risk the market is

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discounting a lot of risk because the odds that whatever

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dot com doesn't make its four hundred million dollars in

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projected app sales in two years well that's pretty good

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could earn a lot less so you know you get

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it You'll keep your shares of whatever dot com if

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you believe they'll really hit the one hundred million in

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earnings on four hundred million of revenues two years from

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now and you'll dump the shares if you don't Well

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what about pepsi Well that's company that financially sounds a

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lot more like caterpillar than whatever dot com the risk

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of people still drinking highly addictive caffeinated fizzy water and

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salted potatoes in five years left pepsi sells a lot

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of data chips Yeah really good odds Pepsi grows a

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bit faster than caterpillar it has a bit higher margins

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and it acquires competitors all the time dipping its toes

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even outside the food and snacks arena So it has

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a really big playing field that it plays on by

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a lot of things and there's that global warming thing

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People drink more when it's hot right So pepsi learn

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about two bucks a share this year and it trades

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that twenty times earnings or forty dollars Well because pepsi

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has long term distribution contract with grocery stores and vending

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machines and theme parks and other weird places it sells

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its wears well pepsi has a pretty highly predictable earning

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stream So when peopie tells the street that it'll learned

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to twenty next year in two forty the following year

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what likelihood Very high that it hits those numbers are

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maybe does little better because it has a history of

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under promising and over delivering and on its two bucks

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forty and earnings at forty dollars pep trades at a

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bit of a premium to the stock market overall that

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to forty and earnings on a forty dollars a share

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price today means that peopie trades at sixteen point six

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times two years out Earnings well the overall stock market

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trades at sixteen times this year's earnings because well earnings

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are growing It trades it about fifteen times earnings two

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years out Why all of these crazy comparisons That air

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probably confusing you well because price to earnings ratios are

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just one measure of the value of a company relative

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to everything else The p e ratio is just one

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metric investors used to measure the value of a company

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and the basic foundation of the idea is simple If

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you invest a dollar in a company today you want

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to be paid back either by getting cash distributions coming

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to you That overtime are much greater than that dollar

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you put in like big dividends and so on Or

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you want the asset itself to simply appreciate it A

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healthy fast pace about eight dollars worth of stock Well

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you want that stock to double every you know three

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four five six years something like that Alright we'll announce

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for your sister's rabbit collection Well that things should multiply

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At a good rate too unless she decides to separate 00:07:47.975 --> [endTime] them

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