PE of 1

When investors buy shares in a company, they have purchased the right to a portion of that company’s future earnings. Past earnings are largely irrelevant in determining whether investors have a good or bad experience. The most important driver of returns is future earnings. Clearly the future is highly uncertain, which is the reason why the share market can be a highly volatile place.

The cocktail of uncertainty and human reaction to that uncertainty can cause severe share market fluctuations. There is no hiding place from that volatility, blue chips are just as prone to it as micro-caps. For example, Amazon fell thirty five percent during the recent and volatile December quarter.

In our opinion, the best and only reliable defence against equity price volatility is to obtain a considerable amount of earnings for the price paid. For example, buying a company that makes a profit of $10m for a price of $10m. This is effectively buying a company on a price to earnings ratio (PE) of 1.

In one year an investor gets 100% of the purchase price back in earnings. This is an extraordinarily quick pay back and gives the investor the opportunity to make very considerable profits if the company can generate more years of $10m. While it’s easy to understand why an investor would jump at such an opportunity, it’s a little harder to imagine why anyone would sell at such a low price. Even the share market at its most capricious struggles to offer up such opportunities. But hopefully this example gives a clear sense of the importance and attractiveness of getting a lot of earnings for the price paid.