Let’s say we have 2 stocks: A Inc and B Inc.
Both companies possess great business models and are financially solid. In the past 12 months, they each generated $100 million in earnings. They both have 100 million shares in issue. So, in that 12-month period, both stocks generated $1 in earnings per share (EPS).
The difference lies in their stock prices. A Inc is trading at $15 a share. Meanwhile, B Inc’s stock price is $30 a share. Hence, A Inc is trading at a P/E Ratio (PE) of 15 while B Inc’s PE is 30.
Because of this, does it automatically mean that Stock A is “cheaper” than Stock B?
The answer is: “It depends”. Obviously, if both companies are expected to continue delivering as much as $100 million per annum for the long-term, Stock A is cheaper as shareholders can earn back their capital in 15 years, which is shorter than 30 years for Stock B.
But, the answer is not as obvious if long-term EPS growth is expected.
Here, let’s assume A Inc is expected to deliver $100 million in earnings a year without growth. In the case for B Inc, it possesses a long-term track record of growing its annual earnings at 15%. So, if we project future earnings and EPS for both companies, we would obtain the following:
Now, let’s calculate their “earn back period”. A Inc has an earn back period of 15 years. This is a straightforward calculation as it takes 15 years of $1 in EPS to earn back invested capital of $15 per share. However, for B Inc, although its PE is 30, its earn back period is 11-12 years, which is 3+ years shorter than A Inc. In this sense, B Inc is cheaper than A Inc despite having higher PE.
So, between price (PE) and EPS growth (Growth), the more important factor that could generate long-term wealth for investors is Growth. This echoes the infamous quote by Warren Buffett:
It’s better to buy a wonderful company at a fair price than a fair company at a wonderful price. Thus, the fundamentals of a business (Growth) is more important than its price.
The lesson is – “Don’t just focus on price or PE. Focus instead on the stock’s EPS growth for the long-term”.
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