Are P/E Ratios Important?

[Note: This column originally appeared on February 8, 1999. All numbers have been updated.]

One of the more interesting questions about investing in stocks centers on the price-to-earnings ratio (P/E). How important is the P/E when deciding on a stock to buy? In chat rooms, I've run into extremes on both ends. I've had people insist that "valuations do not matter." I've had others insist that any stock with a P/E over 15 is overvalued and should not be bought. What is most important here is how we need to look at P/Es as Drip investors.

First, let's dig out our handy spreadsheet and see how the P/E would affect us with an investment like Coca-Cola (NYSE: KO). What I'm going to do is project earnings and dividends forward, and then take a present value. It's actually quite simple in concept, and easy to do with a spreadsheet. Let me explain the concept of "present value" first.

Let's say you wanted to have $1000 in five years. You expect to get a 10% return on your investment, so how much do you need to invest? If that interest is compounded yearly, you need to invest $620, which is the present value of $1000 five years from now at a 10% return.

So, we can consider the cost of Coca-Cola stock to be its present value for a given period and desired return. What is the desired return? There is a capital asset pricing model (CAPM) that determines this, and it involves the risk-free rate of return (usually the return of the 30-year bond), the return of the market, and the beta of the stock. This makes the model a bit more complex, and involves a lot of assumptions. So, I'll just assume that we want a long-term return of 11%, which is the historical market return (even though Drip Port's goal is over 15%).

Now, let's assume that Coke's earnings grow at 15% for our period of concern, which may or may not be too optimistic. I will assume dividends will increase 1% a year.

The $64,000 question is what will Coke be worth at the end of our time period? Will it still carry its high P/E, or will the P/E be much lower. Today, almost all good companies sport very high P/Es due to the low inflation/low interest rate environment that we have. Nobody really can predict where the economy will be in five years. So, let's figure Coke's present value (it trades at $53 today) in five years using several possible future P/E ratios:

P/E    5-Year Present Value
20          35.74
25          43.74
30          51.72
35          59.72

Obviously, Coke appears to be quite expensive today if we expect its future P/E to be 20. It's interesting to look at the present value of the stock if we expect a longer holding period. Let's look at Coke in 10 years with the same assumptions:

P/E     10-Year Present Value
20          47.73
25          57.27
30          66.81
35          76.35

Whether Coke can sustain 15% earnings growth for 10 years is debatable, but if it does, it almost certainly will merit a higher P/E than 20 in my opinion. My guess is it will sport a P/E of about 30 to 35. So, its lofty levels today may not look so lofty 10 years from now.

Now, as Drip investors, we tend to be invested in Rule Maker-type stocks, which will carry a high P/E. (Only a few days remain to sign-up for the Rule Maker Seminar, by the way. It's $35.) Obviously, these kinds of companies could be subject to price corrections, and some time in the future they may not carry such high P/Es.

Drip investing puts us into some rather pricey stocks, like Coca-Cola and Johnson & Johnson. However, since by its nature investing in Drips is a very long-term, steady process, we don't need to worry as much about the present P/Es because dollar cost averaging will help us buy more during price dips. If you'd like to discuss this, please visit the Drip discussion boards linked below.