- Market prices incorporate all kinds of information.
For example, the market prices for firms in a given industry
include average investor expectations
about future earnings growth in that industry
and required rates of return for firms in that industry.
This information is summarized
in the price-earnings or P/E ratio,
and it's defined as price divided by earnings,
hence a clever name, price-earnings ratio.
In this context,
price is the market capitalization of the company,
the amount it would cost you
to buy all the ownership shares.
Earnings is just another way to say net income.
This P/E ratio is an example of a price multiple,
exactly analogous to the price per square foot multiple
commonly used in estimating the value
of residential and commercial real estate.
In general industries in which
expected future earnings growth is expected to be high,
are characterized by high P/E ratios,
like houses in Beverly Hills
with high prices per square foot.
Conversely, in industries
where expected future earning growth is low,
P/E ratios are low,
like houses in my home town of Grantsville, Utah
with lower prices per square foot.
For example, as of July 17th, 2019,
the P/E ratio for Amazon,
a company that is expected
to continue to rapidly grow into the future was 83.
In contrast the P/E ratio for General Motors,
a successful company,
but one that's not expected
to grow rapidly in the future was just six.
On average P/E ratios for public companies
across all industries are about 15.
In other words if a company has net income
or earnings per share of $1, the selling price
of one of that company's shares should be about $15.
Another company with higher earnings of $2 per share
should have a price per share of about $30.
That's $2 earnings per share multiplied by the 15 P/E ratio.
An investor can estimate the value of a company
by using the information
in the P/E ratios of similar companies,
where the P/E ratio comes from other companies
in the same industry
and the earnings are just the net income
from the company's income statement.
This exact process was used by Bill Gates
when his company Microsoft went public in 1986.
As of early 1986,
five of Microsoft's competitors had recently gone public.
These companies had price-earnings multiples
ranging from a low of 10 to a high of 21,
with an average of 15.
To get an initial estimate of the IPO price,
Bill Gates and his investment advisors
simply took Microsoft's $1/10 earnings per share
from the prior year
and multiplied it by the industry average P/E ratio of 15.
This yielded an estimated price of $16.50 per share.
With this $16.50 per share estimated value
Bill Gates and his investment advisors conducted a roadshow,
traveling around to various big cities
and describing Microsoft and its plans
and giving large investors an opportunity
to indicate their interest in buying Microsoft shares
at the $16.50 per share preliminary price.
The roadshow revealed that there was lots of market interest
in Microsoft shares at the price of $16.50.
The investment advisors suggested
raising the price to $24 for the IPO.
But Bill Gates, a little nervous about the embarrassment
of issuing the shares at 24
and having them immediately decline in value
decided that the IPO price would be $21.
And the IPO, unbelievable success.
The shares went public on March 13th 1986 at $21 per share.
By the end of the first trading day
the shares were up to $27.75, a 30% increase in one day.
Microsoft got great publicity from the IPO,
and if you had purchased one of those IPO shares for $21,
you would now have 288 shares because of stock splits
with a total value on July 17th of 2019 of almost $40,000.
Bill Gates, one of the smartest people in the world,
and what tool did he use
to get an initial value for his company?
A simple market-based price multiple, the P/E ratio.