P/E is the most cited statistic about publicly traded companies. The basic math that most people do intuitively is that they look at what a company earns in a year to determine how long it will take them to recover their investment.

The analysis becomes complicated because yearly earnings are not static numbers. They go up and down based on a lot of different factors.
Are sales increasing? (revenue growth)

Are profit margins holding up? (margin compression and pricing power)
Is the company investing cash flow in assets that look promising? (future cash flow from r and d and asset allocation)

Does the company pay a dividend and what is the payout ratio? (If a company has a 100 percent payout ratio that means it is paying all of its earnings as dividends.)

Are there any other risks that put into question the stability of these numbers? (litigation, changes in management, currency risk, aliens invading, etc.)

Earnings are the E in the P/E ratio. All five factors of the above factors, and the perception of those factors by the market, determine the price of a stock at any given point in time. Investors try to determine if their investment will be profitable before they make it. It doesn't matter how long they plan to hold that investment. A "day trader" might have different goals than a "long term" investor but they are all subject to the same factual initial conditions of an investment. Within the context of a normal business environment, the long term outcome of a business is going to be determined by the various factors listed above.

The price of stocks is not determined by people with identical mindsets. Many traders don't care whether or not a price is accurate, they just want it to go in the direction they want it to go. If you are an investor in a company you usually want the price to reflect what your investment should be worth.
"Should be worth" is subjective. Because the next natural question is: In comparison to what?. The bonds of the State of California? Tesla? (TSLA) US Steel (X)?

There are traders and investors that trade and own the above things. The problem is the conflict between the price of an investment in the present and its true risk as an investment. Traders speculating on price in the short term are a huge factor on why stocks can stay mis-priced for long periods of time. For instance a trader might intellectually know that US Steel has a very high probability of eventually going bankrupt, while simultaneously knowing that they can profit off an earnings number that might happen in the next three months. Index funds and 401k plans also prop up stock prices by keeping investors in companies and investments that are quantifiably worse than other investments.

If I were a trader I would never trade an investment where the long term reality was opposed to the short term reality of my trade. If Coca-Cola were undervalued long term, then it must be undervalued short-term as well. It might take a lot of good trades off of the table, but I would never be stuck in a bad position if the market turned against me.

That's never going to happen of course. Wall Street, traders, cnbc, etc. need mistakes in order to succeed. An S & P index fund might provide a positive return, but its a myth that its returns can't EASILY be beaten long term with accurate stock picking. The economic reality of great companies cannot be ignored by the market before the absurdity of mis-pricing becomes obvious to everyone.

I'll give you a great example so that you can start looking for the best long term investments in the S and P 500.

In 2013 Gilead (GILD) had earnings per share of 1.81. Today it has EPS of 9.94. Yet the stock price and market cap is identical to what it was then. So how did that happen?

It has an 88 percent gross margin on its revenue

It has tripled revenue since 2013

It has 32 billion dollars in cash on its balance sheet with a market cap of approx 88 billion

It pays a 3.10% dividend with a 28 percent payout ratio
Its revenue fell in 2016 and is projected to fall in 2017. But because it earned 50 billion dollars in NET EARNINGS between 2013 and 2017 it was able to repurchase 100+ million shares of stock. That lowered the number of total shares outstanding therefore increasing the amount of earnings that EACH SHARE earned.

So if I spent 67 dollars on a share in 2013 that earned 1.81 I would earn 9.94 with that same share today.

Is EPS growth at Gilead sustainable? Well the company currently is purchasing about 1 billion dollars worth of stock back per quarter and has tripled the amount of cash on its balance sheet since 2013. So even if revenue drops say 30 percent y-o-y between 2016 and 2017 it will still earn approx 11 billion dollars in 2017.

My point is that when a company has extremely high gross margins (88) percent, low dividend payout ratio, large amounts of cash on its balance sheet, and consistantly buys back shares, that it can have decreasing revenue and substantially increase EPS. In fact it is likely that even if revenue at the company were to continue to fall another 50 percent from current levels, that it has enough earnings annually and retained, to increase EPS by double over the next few years because of buy-backs.

There is a misconception that a company HAS to increase revenue to become more value as an investment. Traders need that type of momentum to make money in the short term.

But if EPS growth is sustainable that means that the P/E of a company will continue to decrease. People pay attention to P/E numbers. If EPS growth can be quantified to be sustainable then eventually even the shortest term of thinkers will have to respect reality.

What factors make earnings growth less likely?

1. Low gross and net margins (no pricing power, high competition, low differentiation possible, large practical obstacles to cost reduction.)
2. Large fixed costs (capital and labor)
3. High debt levels and cost of capital
4. Inability to repurchase shares vs. other uses for capital

Warren Buffet has commented on how buy-backs can be a bad deal for continuing investors in a company. Executives can "cook-the-books" in ways that are bad for shareholder's but that increase EPS artificially. When a company invests cash that it could use to increase earnings through growth and expansion, that has the potential to undermine the chances the company has to increase earnings long term.

So what about a company with no earnings like TSLA? Can its potential EPS be quantified compared to its current price? I believe that it can. A good starting point would be to look at what it would have to earn to catch up with its current price. The reason growth companies can become "over-valued" in comparison to their earnings is usually because the growth is rapid. There are limits on the absolute ceiling of growth for any company. It is unlikely that Tesla will ever sell 100 billion cars in a year. As the valuation of a company becomes higher it starts to reach the limits of what its maximum realistic valuation could ever be. So while Elon Musk mocks short sellers on Twitter, it becomes less and less likely that the stock is a good investment as the price increases. That is true for ANY company. The higher a market cap of a company goes the less likely it becomes that purchasing its stock is a good investment. How strong the correlation is depends on how management of a company adjusts to the changing conditions of its market(s). An adaptable and stratified company has an advantage over a single category company in an absolute sense, all over things being equal.

People don't like to hear that about their growth stocks. They want it to be true that a company with no earnings can be just as valuable as a company that earns a lot now. But the equation always has to come back to earnings and risk. How much will a dollar I invest now eventually earn?

Being able to buy sustainable EPS growth is the holy grail. If every road eventually leads to earnings then it makes sense to pick the companies that have the most factors in favor of achieving the highest earnings per share possible with the lowest amount of risk.

I'm a newb so I found this to be an informative write-up. Thanks.

+1

I will just state that investors are not compensated with an equity risk premium for undertaking individual company risk. Individual company risk can be diversified away. So you can do all the analysis on an indivual company you want but in all likilihood you probably aren't smarter than the market. Of course there are people that have a lot of experience with individual companies and markets the companies sell in but if you aren't one of those people I am going to state that reading all the financial data avaiable, 10-Qs, annual reports and what have you almost certainly won't give an edge IE you probably won't be compensated sufficiently for the risk you are taking.

I totally encourage people interested in the stock market to read all financial data they can absorb including 10-Qs and annual reports though. It takes some patience and time to learn the basics of finance. Knowledge is power. Just my $0.02 from a guy on an Internet forum.

definitely not CACC...