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In the 1987 shareholder letter to GEICO stockholders, Lou Simpson, one of the most successful investors of all time, described what he looked for in a potential investment. They included “Think independently”, “Invest in high-return businesses run for shareholders,” “Pay only a reasonable price, even for an excellent business,” “Invest for the long-term,” and “Do not diversify excessively.” He also mentioned a concept that we have only briefly touched upon and that is the long-term treasury yield and how it has important implications in the valuation you should use to determine the relative attractive of a company.

Let’s first understand what Overvalued means:

The P/E ratio (price-to-earnings ratio) of a stock (also called its “P/E”, or simply “multiple”) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. The P/E ratio can therefore alternatively be calculated by dividing the company’s market capitalization by its total annual earnings. Unlike the EV/EBITDA multiple which is capital structure-neutral, the price-to-earnings ratio reflects the capital structure of the company in question. The price-to-earnings ratio is a financial ratio used for valuation: a higher P/E ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with a lower P/E ratio. The P/E ratio can be seen as being expressed in years, in the sense that it shows the number of years of earnings which would be required to pay back purchase price, ignoring inflation and time value of money. The P/E ratio also shows current investor demand for a company share. The reciprocal of the P/E ratio is known as the earnings yield. The earnings yield is an estimate of the expected return from holding the stock if we accept certain restrictive assumptions.

The P/E ratio is defined as:

The price per share in the numerator is the market price of a single share of the stock. The earnings per share in the denominator depends on the type of P/E:

• “Trailing P/E” or “P/E ttm”: Here earnings per share is the net income of the company for the most recent 12 month period, divided by the number of shares issued. This is the most common meaning of “P/E” if no other qualifier is specified. Monthly earning data for individual companies are not available, so the previous four quarterly earnings reports are used and earnings per share are updated quarterly. Note, each company chooses its own financial year so the timing of updates will vary from one to another.
• “Trailing P/E from continued operations”: Instead of net income, this uses operating earnings, which exclude earnings from discontinued operations, extraordinary items (e.g. one-off windfalls and write-downs), or accounting changes. Note, longer-term P/E data, such as Shiller’s, use net earnings.
• “Forward P/E”, “P/Ef”, or “estimated P/E”: Instead of net income, this uses estimated net earnings over next 12 months. Estimates are typically derived as the mean of a select group of analysts (note, selection criteria is rarely cited). In times of rapid economic dislocation, such estimates become less relevant as the situation changes (e.g. new economic data is published, and/or the basis of forecasts becomes obsolete) more quickly than analysts adjust their forecasts.

For example, if stock A is trading at $24 and the earnings per share for the most recent 12 month period is $3, then stock A has a P/E ratio of 24/3 or 8. Put another way, the purchaser of the stock is paying $8 for every dollar of earnings. Companies with losses (negative earnings) or no profit have an undefined P/E ratio (usually shown as Not applicable or “N/A”); sometimes, however, a negative P/E ratio may be shown.

By comparing price and earnings per share for a company, one can analyze the market’s stock valuation of a company and its shares relative to the income the company is actually generating. Stocks with higher (and/or more certain) forecast earnings growth will usually have a higher P/E, and those expected to have lower (and/or riskier) earnings growth will usually have a lower P/E. Investors can use the P/E ratio to compare the value of stocks: if one stock has a P/E twice that of another stock, all things being equal (especially the earnings growth rate), it is a less attractive investment. Companies are rarely equal, however, and comparisons between industries, companies, and time periods may be misleading.P/E ratio in general is useful for comparing valuation of peer companies in similar sector or group.

Since 1900, the average P/E ratio for the S&P 500 index has ranged from 4.78 in Dec 1920 to 44.20 in Dec 1999, with an average around 15.The average P/E of the market varies in relation with, among other factors, expected growth of earnings, expected stability of earnings, expected inflation, and yields of competing investments. For example, when US treasury bonds yield high returns, investors pay less for a given earnings per share and P/E’s fall.

Share prices in a publicly traded company are determined by market supply and demand, and thus depend upon the expectations of buyers and sellers. Among these are:

• The company’s future and recent performance, including potential growth;
• Perceived risk, including risk due to high leverage;
• Prospects for companies of this type, the market sector.

By dividing the price of one share in a company by the profits earned by the company per share, you arrive at the P/E ratio. If earnings per share move proportionally with share prices the ratio stays the same. But if stock prices gain in value and earnings remain the same or go down, the P/E rises.

The earnings figure used is the most recently available, although this figure may be out of date and may not necessarily reflect the current position of the company. This is often referred to as a ‘trailing P/E’, because it involves taking earnings from the last four quarters.

AN EXAMPLE OF AN OVERVALUED COMPANY (NFLX) COURTESY OF F.A.S.T. GRAPHS

Graph Number One: Netflix’s Exceptional Earnings Growth

With our first graph, we plot Netflix’s earnings per share growth (orange line) since calendar year 2007.  At the bottom of the graph you will see that earnings grew from $.94 in 2007, to $1.43 in 2008, to $2.05 in 2009, to $3.06 in 2010, and earnings are estimated, based on management’s most recent guidance, to be approximately $4.03 by year-end 2011. To the right of the graph we learn that Netflix’s average earnings growth rate since 2007 was an exceptional 39.2% (see red circle).

Graph Number Two: Netflix with Price Correlated to Earnings

With graph number two we add two very important lines.  First, we add the normal price earnings ratio that the market had historically applied to Netflix.  The normal PE ratio for Netflix calculated out to be 29.6, which is almost twice the normal PE ratio of 15 which is applied to the average company. On the other hand, Netflix’s exceptional earnings growth justified this level of premium valuation.  Nevertheless, starting in March of 2010 the black price line began to move above the blue normal price earnings ratio line before peaking in late July.

We argued that this profitable enterprise had become dangerously overvalued. At the time of that writing Netflix was trading at $223.20 and it continued rising to over $304 by late July, effectively becoming more and more overvalued with each passing day. However, by the end of July the rubber began meeting the road and Netflix’s stock price was quickly reverting to the mean which it clearly reached on September 30, 2011.

However, recent earnings guidance of a few quarters worth of losses has dramatically altered expectations of future earnings. Consequently, the market is attempting to establish a new and lower mean.  Time will tell where this ends up, however, most likely Netflix will go much lower.

Avoiding the Obvious Mistake

Based on the undeniable relationship between earnings and market price, investing in Netflix when it was so massively overvalued, even when expectations about future earnings growth were still very high, represented an obvious mistake that could have, and should have been avoided. Mathematically, it should have been clear that Netflix’s earnings and cash flow did not support their lofty valuation.

Although it’s true that speculators and/or momentum investors could have bought Netflix in early 2011 and made a very high rate of return by summer, assuming of course that they then sold, that action cannot be properly described as investing. Later in this article we will discuss the difference between investing versus speculating more fully.

Here’s a ANOTHER great website to use for graph ratio’s named YCharts.com