When someone takes ownership of a stock, they are essentially buying a piece of the company’s future earnings. Combining ideas from Peter Lynch’s book “One Up on Wall Street” and Joel Greenblatt (Trades, Portfolio)’s “The Little Book that Still Beats the Market,” there is an interesting way to look at P/E ratios.
Peter Lynch said that a P/E ratio can be thought of as, “How many years will it take to earn your money back?” So if a company has a P/E of 12, it will take 12 years of earnings to equal the amount of money used to buy the stock.
Joel Greenblatt (Trades, Portfolio) stresses earnings yield, the inverse of P/E. If a stock has a P/E of 15, its earnings yield is 1/15 or 6.67 percent. Earnings yield is used in the same way as yield on a bank account or a bond. The historical average on the stock market is between 10 percent and 12 percent. If a stock has a lower earnings yield than 10 percet to 12 percent, an investor might be better off in a stock index fund with less risk. If you cannot get at least a 6 percent earnings yield on a stock, you would probably be better off finding a bond.
Combining both of the ideas, I would like to have at least a 10 percent to 12 percent earnings yield on a stock. Using the inverses, that would equate to P/E ratios of 8.33 and 10 (1/0.12 and 1/0.10). According to Peter Lynch, the payback period will be eight to 10 years without considering compounding.
There are plenty of stocks with a P/E higher than 10 that are worth buying if they are growing. In order to meet my payback period, I would need the earnings to grow at a certain rate. Here is a table of hypothetical stocks: Company A, Company BÂ and Company C. The table shows their earnings per share (EPS) for each year and how fast they would need to grow in order to meet the payback period.
| Stock | Price | P/E | EPS(0) | EPS(1) | EPS(2) | EPS(3) | EPS(4) | EPS(5) | EPS(6) | EPS(7) | EPS(8) | Total | Growth Rate |
| Company A | 50 | 15 | 3.33 | 3.80 | 4.32 | 4.92 | 5.61 | 6.39 | 7.27 | 8.28 | 9.44 | 50.03 | 13.89% |
| Company B | 50 | 30 | 1.67 | 2.15 | 2.78 | 3.60 | 4.65 | 6.01 | 7.77 | 10.05 | 12.99 | 50.02 | 29.26% |
| Company C | 50 | 100 | 0.50 | 0.79 | 1.24 | 1.94 | 3.06 | 4.81 | 7.57 | 11.90 | 18.71 | 50.01 | 57.27% |
In order to meet my payback period of eight years, a stock with a P/E would need to grow its earnings at an annual rate of 13.89 percent for the eight years. A stock with a P/E of 100 would need to grow its earnings at an annual rate of 57.27 percent in order to meet the payback period of eight years. Also keep in mind that if a stock has a P/E of eight or lower, it would still be necessary to investigate the stock to determine if the earnings are stable.
In conclusion, if the expected earnings on a stock over the next eight years do not add up to the purchase price, it might not be worth buying since a better earnings yield can be found in an index fund.
