30 November 2011

Price per Earnings (PE) Ratio (PER)- Controllable Variable or Uncontrolable Variables

Controllable variable is a variable which is under control by us, while Uncontrollable variable is its opposite.
For Price per Earnings (PE) Ratio, or PER, we can analogue the price is a controllable variable and the Earnings is an uncontrollable variable.

The price that we are willing to pay to a particular investment is controllable by ourself.  Although sometimes people will tell us that a particular business "should" have particular PER, it does not mean we should invest it with the PER. In most of the time, the higher the PER, the lower the safety margin. For example, if a particular investment already has PER of 20, (Price/Earning = $2.00/$0.10 = 20), with estimated profit of 100%, its PER must soar to 40,with the assumption that its earning is maintained.

Next, eventhough the uncontrollable variable (Earning) is out of our control, we can somehow estimate its future value based on its business model, industry sector, economy trend, business prospect etc.
We use the previous example again for a simple demostration with a case of growing earning. If we expect the earning of a particular investment will be improved with growing rate of 50%, with PER of 20 to invest in the business still considered a good deal as stated below:

Year: Price/Earning
0: $2.00/0.10 = 20
1: $2.00/0.15 = 13.33
2: $2.00/0.225 = 8.89
3: $2.00/0.3375 = 5.93
4: $2.00/0.50625 = 3.95
5: $2.00/0.759375 = 2.63

Accumulative Earnings
0: 0.10
1: 0.25
2: 0.475
3: 0.8125
4: 1.31875
5: 2.078125

In other words, we should be able to breakeven by the fifth year of this investment with initial PER of 20. However, I would like to highlight that this is still quite risky if the expected growing rate is lower than our expectation. Therefore, for the sake of safety margin, I personally perfer to wait for "good entry point". For instance, with PER of 10 to invest in this investment, obviously, the period of breakeven will be fast, so the risk is relatively lower.

Therefore, after having a certain understanding of the future of the uncontrollable variable of a particular business, all we need to do is to "control" what we can control, that is, using a good price (the lower, the better) to buy it in order to hedge the uncertainty (risk) of uncontrollable variable (future earning).

That's all for today. More fascinating articles and sharing will be updated from time to time in Xaivier Blog. So, you are welcome to subscribe our feed, look at our sitemap or simply visit our Homepage.

Written by: Xaivier Chia


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