Lesson 11 of 12 · 4 min · Valuation

Compared to what?

A number only means something next to another number. Here are the three yardsticks.

1. Is a P/E of 20 high? You cannot tell from the number alone. You need a yardstick, and there are three good ones.

2. Yardstick one: companies in the same business. Industries differ hugely. A supermarket chain typically keeps 2 to 4 cents of operating profit per dollar of sales. A big software company can keep 25 cents or more.

3. So compare a supermarket with supermarkets, and a lemonade chain with other lemonade chains. Say three listed rivals of Lemon Co have a median P/E of 17 and a 14% operating margin.

4. Lemon Co costs more than its rivals: a P/E of 20 against 17. But it is also the better business: a 20% margin against 14%. A higher price for higher quality can be fair. A higher price for lower quality rarely is.

5. Yardstick two: the company’s own past. Over ten years, Lemon Co’s P/E has ranged from 14 to 24, usually around 18. Today’s 20 is a little above its normal, nowhere near an extreme.

6. Yardstick three: the safe alternative. Say a government bond pays 4%. Lemon Co’s earnings yield is 5%, and with 4% growth you might expect about 9%. The gap of about 5 points is your pay for taking business risk.

7. Ryufin’s stock pages do the first yardstick for you: each company is shown next to the median of its peers. The other two you can check in a minute.