The Value of a Company Relative to Bonds

- Price / Earnings = P/E Ratio
- Earning / Price = Rate-of-Return (%)

An important question these ratios provide an answer to is, “how long will it take to break-even on the investment?” In other words, if a business continues to grow its earnings at a rate of “x” % annually, how long would it take for the earnings to amount to the investment initially placed in the business (i.e., its stock)?

The P/E ratio (at the time of purchase) tells us this information about the business. For example, if a stock sells for $25 per share, and the business is generating $5 per share in earnings then the P/E ratio of 5 ($25 / $5 = 5) tells us that investors in the market are willing to pay 5 times whatever the company earns ($5 in the example above). Therefore, if the company has stable and predictable earnings and it continuously grows them at a satisfactory rate, then the investor can expect to receive his initial investment of $25 per share back in roughly 5 years. Put another way, the P/E ratio can tell you how ling it would take to break-even on your purchase of shares in a business.

Another important question to ask is, “how will the investment compare with the return that can be achieved through a long-term government bond?”

This is an important question to ask regarding any investment because ultimately all investments compete with one another – as if they were athletes in a track race. This is logical belief held by Buffett. The answer to this question can be found by figuring out the E/P (earnings-to-price) ratio. This is the exact reverse of the P/E ratio. Therefore, “flipping” the numbers in the P/E will tell you your approximate rate-of-return for the first year of operations (the year you buy the stock).

The E/P ratio is used by Buffett as a comparison tool to determine whether the business in question would yield an adequate return in relation to other investments if it is invested in. To do this, Buffett compares the figure arrived at by the E/P ratio with return offered by the “risk-free-rate”. The risk-free-rate is the after-tax rate of return offered by a long-term (10+ years) government bond, or the bank’s annual interest rate, whichever is higher.

If the E/P figure is approximated at an after-tax rate-of-return which falls short of the risk-free-rate, then it would be foolish to invest in the business.

The bottom line is, the lower the P/E the better. This is because:

1) the lower the P/E ratio
2) the higher the E/P ratio
3) the lesser time is required to break-even on the investment
4) the quicker you will start making a profit
5) the larger will be your after-tax profit
6) and the greater will be your ultimate rate-of-return.

So, by taking a single measure (as looking for a low P/E) you will accomplish five additional, effortless tasks.