Ask Colin

Why does Ian Huntley say PE ratio and EPS growth should ideally be the same, when they rarely are?

I think that Ian Huntley has simply expressed himself poorly on this point.

What he is talking about, I think, is a common method of deciding whether a company is under or over priced. This is based on the idea that PE ratios bear a direct relationship to earnings growth.

Think of it this way - the PE ratio is simply the number of years it will take you to recover your purchase price from the earnings of the business. Therefore, if you have a choice of buying two businesses and it takes you 10 years to get your money back from one (PE of 10) and 12 years to get your money back from the other (PE of 12), then all things being equal, you will go for the 10-year one, because you are buying the earnings more cheaply. However, all things are rarely equal and one aspect is that companies grow over time. Thus, if the company which will can be bought for 12 times earnings is growing very rapidly, while the other is not growing at all, you will probably do better to buy the one with the higher multiple, because "E" is going to grow and the ratio to today's "P" will be likely to fall below 10 in a few years.

It follows from this that the higher the PE ratio, the higher the earnings growth rate you need to justify paying such a high price relative to earnings. There is a rough rule of thumb that the "about right" price is where the PE ratio equals the rate of growth in earnings. Hence, Ian Huntley is saying that this is the "ideal".

The way you use this is to compare PE ratio to EPS growth rate. Where the PE ratio is much higher than the EPS growth rate, the company is expensive in those terms. Where the PE ratio is lower than the EPS growth rate, the company is cheap in those terms.

This can be used to search the database of companies by programming a search of all companies that have a PE ratio less than its EPS growth rate. This will give a list of companies that are cheap in those terms and which will enable you to focus your detailed research on that list rather than waste time on companies you know to be too expensive.

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