Subject: Re: What's Most Important? (was PEs: Pegging Relationships and Ratios)
From: "C. H. Hodgkin"
Date: Thu, 23 Jun 2005 21:24:42 -0700 (PDT)
X-Message-Number: 1
--- Jim Thomas wrote:
> Can you share your five minute description of the
> simple concept behind the SSG?
>
> -Jim Thomas
We can look historically at a stock's price performance, especially it's high and low prices each
year. (Show the price bars on page 1 of the SSG.)
We can look historically at a stock's earnings per share. (Show earnings line on the SSG.)
From these three numbers each year (high price, low price, and earnings) we use simple
arithmetic to calculate two more numbers:
High PE ratio is high price divided by earnings.
Low PE ratio is low price divided by earnings.
Now, this formula is PE = Price / Earnings.
By simple algebra, we can re-work that formula so that it reads:
Price = Earnings x PE.
Ergo. If we predict what the earnings will be in five years, and can predict the PE ratio in five
years, we can predict what the high and low prices will be in five years.
What this requires is that we select stocks that:
1. We think we can predict with reasonable accuracy the earnings in five years. Our
assumption is that, if nothing else changes dramatically, a stock with a basically straight
earnings line for the past ten years will continue to grow at approximately the same rate,
so we can predict its earnings in five years.
2. The PE ratios have been relatively consistent for the past five to ten years, so we can
predict that they will remain approximately the same for the next five years.
Now, of course there are complexities.
But the core principle of the SSG is triviality itself. Take the PE = Price / Earnings ratio and
just recast it to read Price = PE x Earnings. Then pick stocks where we have some confidence
that the Earnings and PE values can be reasonably predicted five years from now. Multiply, and
you have the price range five years from now.
Now, isn't that simple?