[P/E] vs growth of a stock

[FishHooks]

I was reading A Random Walk Down Wall Street (first investing book, just getting into this stuff only 18)and come upon something I was't too clear about. For those of you that have the book what i'm talking about is in Chapter 5.

He talkes about the [P/E] multiple with relation to the stock growth. He shows that the higher the [P/E] the higher the expected growth is. First of all why is this? Secondly how/if is this maintainable? You would think after the growth period the stocks [P/E] mulitple would be really high, even after the growth and the stock would just have to loose its value once it started to stable out. He might talk more indepth about this later in the book, just posted it now so I wouldn't forget.

[Sniper]

The Price/Earnings ratio is not a constant.

A company with high future earnings growth potential will generally have a higher P/E than a company with low future earnings growth potential.

As a company moves thru its natural development from a growth company to a dinosaur, you can expect that the P/E will adjust itself over time to account for the change in future earnings growth potential.

What he said. Take GOOG as an example. Its PE is 80, compared to the market average of 30. The reason for this is, people expect its earnings to grow much faster than the market average. What investors hope will happen is that GOOG's earnings will quadruple, and its share price will double, leaving it with a PE of 40.

[FishHooks]

I get what you guys said because I said most of it in my first post.

"What investors hope will happen is that GOOG's earnings will quadruple, and its share price will double, leaving it with a PE of 40."

If their earing quadruple wont tons of people be in on the stock and the PE will be much higher than 40?

My first question was why do stocks with with high growth projections have a high PE? Is that because mosts stocks that are growing normally just have small earings because they are just starting out and many people are just buying it to get in ont the stock cauing the PE to go up?

I'm just not getting WHY high growth stocks generally have a high PE.

P.S. I know PE is not constant.

[Delphin]

[ QUOTE ]
I get what you guys said because I said most of it in my first post.

"What investors hope will happen is that GOOG's earnings will quadruple, and its share price will double, leaving it with a PE of 40."

If their earing quadruple wont tons of people be in on the stock and the PE will be much higher than 40?

My first question was why do stocks with with high growth projections have a high PE? Is that because mosts stocks that are growing normally just have small earings because they are just starting out and many people are just buying it to get in ont the stock cauing the PE to go up?

I'm just not getting WHY high growth stocks generally have a high PE.

P.S. I know PE is not constant.

[/ QUOTE ]

Basic economics. The price depends on the demand. Lots of people want to buy stock in a company that is projected to grow quickly. They bid the price up higher. As the company grows and it's future projected growth starts to cool off, there is less demand and the price stops growing as rapidly. The company is still growing, but some investors start looking for companies that are growing faster, this means that less people are buying the stock and the price doesn't continue to go up as rapidly.

[meow_meow]

Let us look at an example.

Company A has current earnings of $1/share.
Company B has current earnings of $1/share.

Company A is expected to show earnings growth of 25%/a for the next ten years.
Company B is expected to show earnings growth of 10%/a for the next ten years.

Which stock will be more expensive?

Obviously company A will trade at a higher price, even though both companies earned $1/share last year.

A reasonable rule of thumb is that the PE ratio / earnings growth should be in the vicinity of 1.

Therefore in the above example, company A is probably trading around $25/share, and company B around $10/share, all else being equal.

Hope that helps.

[Sniper]

[ QUOTE ]
I'm just not getting WHY high growth stocks generally have a high PE.

[/ QUOTE ]

At its simplest, when you buy a company, you are paying for the value of its future earnings.

[AceHigh]

[ QUOTE ]
I'm just not getting WHY high growth stocks generally have a high PE.

[/ QUOTE ]

I think you are confused by Lynch's statement. P/E and growth are not necessarily related.

A companies price is based on it's expected future earnings. So past earnings may under represent it future earnings and it's current price. If a has been struggling to make a profit and something happens that it suddenly is expected to become hugely profitable in the near future, it's P/E could very well be astronomical. This happens fairly often with new companies or companies that are engaged in speculative ventures.

[squiffy]

If ODP will earn profits in 2005 of $1 a share and trades at a market price of $10 a share, then it has a PE ratio based on future expected earnings of 10/1. You need to invest $10 to earn $1 in profit. So a 10% return. If the profit is paid out entirely in dividend fine. If the profit is retained by the company, then theoretically it is invested in building stores, hiring employees, so that the company has retained that $1 in value per share. So the stock price should gradually increase to reflect that value.

If BIDU or YAHOO earns $1 per share in profits and sells for $100 per share, then it has a higher PE of 100 to 1. You have to invest $100 per share to earn $1.

So if earnings stay constant in 2006 and if the likelihood of either company going broke is equal, and if the likelihood of either company growing long term earnings is equal,it's idiotic to buy BIDU or YAHOO stock.

For $100 you can buy only 1 share of BIDU or YAHOO and earn $1, which is a 1% return on your money.

For $100, you can buy 10 shares of ODP and earn $10, which is a 10% return on your money.

So you would have to be insane to invest in BIDU unless you think it is growing so fast that earnings will be increasing at an insane rate. Sometimes this is true.

Let's say next year you expect BIDU to earn $50 a share and ODP to only earn $1 per share. Now BIDU's real PE is 2/1. You invest $100 to earn $50. Or you invest $2 to earn $1 a 50% return on your money.

If BIDU is growing fast enough and ODP is not growing. Then you can invest $100 in BIDU to make $50 or you can invest $100 in ODP to make $10. So BIDU is the better return, if your expectations of future profits are accurate.

The bottom line is -- which investment will earn more money, per dollar invested.

So that is ONE THEORY or ONE APPROACH -- that stock investing is all about expectations of future profit. You invest money to make money. You want to know how much money the company will make and you hope it is not committing accounting fraud and lying about the money it made and you hope it will grow and make more and more money.

Future expected earnings vs. risk of bankruptcy.

You invest in F because it has factories that make cars. They sell cars and make a profit. Each share you buy earns a certain amount of profit. That is the theoretical return on your invested money, as compared to a bank account or CD.

But there is also risk of losing your ass if you buy Krispy Kreme or Enron and their books are cooked.

Other approaches are looking at the shape of the chart and predicting future price movements from the shape of the chart. It looks like a bunny rabbit. Maybe the price will go up tomorrow.

Or momentum investing. It went up 5% yesterday. Maybe it will keep going up today. BIDU is a hot IPO maybe the initial offering price will double or triple. Let's bet $10 million dollars and see what happens. Red, black, or green.