Is P/E useful?

P/E is probably the most widely used valuation tool. But how useful is it when comparing companies? P/E is of course price divided by earnings. But is each dollar of earnings equal? My answer is no. Other factors are also important, especially return on equity, or ROE.

ROE is the ratio of earnings to stockholder equity. It measures how effective the business is at turning investment into earnings. It's not rocket science - would you rather own a company that requires $100 to produce an extra $5 annually of earnings, or one that can produce $25 of earnings for the same $100 of investment?

As an example, take two companies. Each starts with the same earnings and reinvests it. One earns 10% on it's equity, the other 20% on equity.

	Company A				Company B
	Equity	Earnings			Equity	Earnings
10.00%	2000	200		20.00%	1000	200
10.00%	2200	220		20.00%	1200	240
10.00%	2420	242		20.00%	1440	288
10.00%	2662	266.2		20.00%	1728	345.6
10.00%	2928.2	292.82		20.00%	2073.6	414.72
10.00%	3221.02	322.1		20.00%	2488.32	497.66
10.00%	3543.12	354.31		20.00%	2985.98	597.2
10.00%	3897.43	389.74		20.00%	3583.18	716.64
10.00%	4287.18	428.72		20.00%	4299.82	859.96
10.00%	4715.9	471.59		20.00%	5159.78	1031.96
10.00%	5187.48	518.75		20.00%	6191.74	1238.35

The difference between companies A and B are apparent over time. Company A has doubled its earnings by year 8. In contrast, company B has doubled its earnings by year 4. After ten years, company B has expanded its earnings by a factor of 6, while company A has not yet tripled its earnings.

This is why an investor can often pay more for shares of a high ROE company than a low ROE company. The caveat being that the company must be able to reinvest its earnings. Companies in dying industries probably do not have an opportunity to reinvest in their business this way. My experience is that companies in growing industries with high ROE can be good investments provided that you do not overpay. The overpaying part is often a problem as these are frequently the type of companies that command very high P/Es. However paying a market P/E multiple for such a company is often not a bad purchase.