In this video, learn how to estimate the value of a company using the price-earnings, P/E, ratio.
- Market prices incorporate all kinds of information. For example, the market prices for firms in a given industry include average investor expectations about future earnings growth in that industry and required rates of return for firms in that industry. This information is summarized in the price-earnings or P/E ratio, and it's defined as price divided by earnings, hence a clever name, price-earnings ratio. In this context, price is the market capitalization of the company, the amount it would cost you to buy all the ownership shares. Earnings is just another way to say net income. This P/E ratio is an example of a price multiple, exactly analogous to the price per square foot multiple commonly used in estimating the value of residential and commercial real estate. In general industries in which expected future earnings growth is expected to be high, are characterized by high P/E ratios, like houses in Beverly Hills with high prices per square foot. Conversely, in industries where expected future earning growth is low, P/E ratios are low, like houses in my home town of Grantsville, Utah with lower prices per square foot. For example, as of July 17th, 2019, the P/E ratio for Amazon, a company that is expected to continue to rapidly grow into the future was 83. In contrast the P/E ratio for General Motors, a successful company, but one that's not expected to grow rapidly in the future was just six. On average P/E ratios for public companies across all industries are about 15. In other words if a company has net income or earnings per share of $1, the selling price of one of that company's shares should be about $15. Another company with higher earnings of $2 per share should have a price per share of about $30. That's $2 earnings per share multiplied by the 15 P/E ratio. An investor can estimate the value of a company by using the information in the P/E ratios of similar companies, where the P/E ratio comes from other companies in the same industry and the earnings are just the net income from the company's income statement. This exact process was used by Bill Gates when his company Microsoft went public in 1986. As of early 1986, five of Microsoft's competitors had recently gone public. These companies had price-earnings multiples ranging from a low of 10 to a high of 21, with an average of 15. To get an initial estimate of the IPO price, Bill Gates and his investment advisors simply took Microsoft's $1/10 earnings per share from the prior year and multiplied it by the industry average P/E ratio of 15. This yielded an estimated price of $16.50 per share. With this $16.50 per share estimated value Bill Gates and his investment advisors conducted a roadshow, traveling around to various big cities and describing Microsoft and its plans and giving large investors an opportunity to indicate their interest in buying Microsoft shares at the $16.50 per share preliminary price. The roadshow revealed that there was lots of market interest in Microsoft shares at the price of $16.50. The investment advisors suggested raising the price to $24 for the IPO. But Bill Gates, a little nervous about the embarrassment of issuing the shares at 24 and having them immediately decline in value decided that the IPO price would be $21. And the IPO, unbelievable success. The shares went public on March 13th 1986 at $21 per share. By the end of the first trading day the shares were up to $27.75, a 30% increase in one day. Microsoft got great publicity from the IPO, and if you had purchased one of those IPO shares for $21, you would now have 288 shares because of stock splits with a total value on July 17th of 2019 of almost $40,000. Bill Gates, one of the smartest people in the world, and what tool did he use to get an initial value for his company? A simple market-based price multiple, the P/E ratio.
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