Price-To-Innovation-Adjusted Earnings

Finance a lash up What is the price to earnings

ratio All right You just inherited a thousand shares of

whatever dot com which trades publicly for twenty bucks a

share And you also inherited a thousand shares of pepsi

And that stock trades publicly for forty bucks a share

Your sister got the pewter bunny rabbit collection but well

you can live with that fact that you take the

thousand shares All right so what on earth do you

do now What do you do with these things Well

you have no idea Because you're an orthodontist and you

have your hands in wet mouths all day Well if

you'd inherited a truckload of floss well then we totally

know what to do with it All right Will you

check out the brokerage reports from morgan stanley on whatever

dot com it has one hundred million dollars in revenue

and no earnings no profits Well what Our earnings again

Oh yeah This revenues from whatever's app sales at a

buck Each one hundred million of them minus its cost

of goods sold Well it had to pay fifty million

bucks to apple and others to get it saps out

There well then it had a small army of engineers

and product people on payroll to build The app will

subtract another thirty million box then it had rent in

legal expenses and health care insurance and office things like

computers and app servers All of that added up to

be twenty million dollars and because of the accounting laws

you have to subtract it all last year Even though

the app it lasts a long time i had to

take it all off the top It had a hundred

million dollars in revenues and a hundred million dollars in

expenses and no earnings but it has fifty million shares

outstanding which when multiplied by twenty bucks a share that's

What the market's paying for it twenty dollars share It

gives it a market value of a billion bucks Take

the shares outstanding kinds of market price to get what

the company's worth at least according to wall street buying

and selling the shares Oh it has fifty million dollars

in cash on the books and no debt so the

market is valuing the equity of the company at nine

hundred fifty million dollars meaning it's valuing the earnings power

Of the company in the future in his hands at

nine Fifty alright so you wonder forth an honest and

would be flossed cellar that you are How khun something

with no profits no earnings be worth a billion dollars

Well you read through the report which notes that the

revenues are growing really fast like one hundred percent a

year and that the market whoever that is believes that

the company will have two hundred million in revenues next

year and for hundred million the following year and on

four hundred million of revenues it will have one hundred

million dollars in net earnings It'll also produce fifty million

in cash along the way so in two years it

will have one hundred million dollars in cash on the

books and no debt If you go back and think

about that that you could subtract one hundred million from

the billion and it's the nine hundred million of equity

value back we'll get All right So you ponder that

means that today at a billion dollars i'm paying if

i buy it at twenty bucks a share i'm paying

nine times the earnings expected in two years Two years

From now for the equity value of this company huh

Well is nine times earnings cheap expensive Attaway frame the

notion Well the average snp company trades it about sixteen

times two years out earning something like that But the

average company is totally different from whatever dot com The

average company is like a caterpillar Tractors or well pepsi's

kind of average Wells fargo kind of average Well it's

a mature company unlike whatever dot com and the people

who write for shmoop but not mature way No Well

caterpillar has been around for a century has a stable

set of fires And you know what are the odds

People still need tractors to mine food in five years

You have pretty good odds whereas whatever dot com might

have totally evaporated by them Yeah well what about revenue

growth Yep Caterpillars matured gross revenues that only about eight

percent a year in a good year And it has

a lot of capital expenses Well every decade or so

it needs a new smelting plant to smelt engines and

redo its manufacturing process Tio you know keep up with

the joneses or rather the blues or chains Oh and

it pays a small dividend yeah helps well tough company

to compare with whatever dot com but caterpillar trades at

about sixteen times thiss years earnings and it'll grow earning

slowly and you note that it trades at fifteen times

and extras projected earnings and fourteen times the following year's

earnings So that's interesting caterpillar trades at a hire multiple

on two year forward earnings than whatever dot com who

does that make sense It's nowhere near ist sexy a

company but it must be the risk the market is

discounting a lot of risk because the odds that whatever

dot com doesn't make its four hundred million dollars in

projected app sales in two years well that's pretty good

could earn a lot less so you know you get

it You'll keep your shares of whatever dot com if

you believe they'll really hit the one hundred million in

earnings on four hundred million of revenues two years from

now and you'll dump the shares if you don't Well

what about pepsi Well that's company that financially sounds a

lot more like caterpillar than whatever dot com the risk

of people still drinking highly addictive caffeinated fizzy water and

salted potatoes in five years left pepsi sells a lot

of data chips Yeah really good odds Pepsi grows a

bit faster than caterpillar it has a bit higher margins

and it acquires competitors all the time dipping its toes

even outside the food and snacks arena So it has

a really big playing field that it plays on by

a lot of things and there's that global warming thing

People drink more when it's hot right So pepsi learn

about two bucks a share this year and it trades

that twenty times earnings or forty dollars Well because pepsi

has long term distribution contract with grocery stores and vending

machines and theme parks and other weird places it sells

its wears well pepsi has a pretty highly predictable earning

stream So when peopie tells the street that it'll learned

to twenty next year in two forty the following year

what likelihood Very high that it hits those numbers are

maybe does little better because it has a history of

under promising and over delivering and on its two bucks

forty and earnings at forty dollars pep trades at a

bit of a premium to the stock market overall that

to forty and earnings on a forty dollars a share

price today means that peopie trades at sixteen point six

times two years out Earnings well the overall stock market

trades at sixteen times this year's earnings because well earnings

are growing It trades it about fifteen times earnings two

years out Why all of these crazy comparisons That air

probably confusing you well because price to earnings ratios are

just one measure of the value of a company relative

to everything else The p e ratio is just one

metric investors used to measure the value of a company

and the basic foundation of the idea is simple If

you invest a dollar in a company today you want

to be paid back either by getting cash distributions coming

to you That overtime are much greater than that dollar

you put in like big dividends and so on Or

you want the asset itself to simply appreciate it A

healthy fast pace about eight dollars worth of stock Well

you want that stock to double every you know three

four five six years something like that Alright we'll announce

for your sister's rabbit collection Well that things should multiply

At a good rate too unless she decides to separate 00:07:47.975 --> [endTime] them