It’s the Growth in Earnings, Stupid.

In order to solve the problem, one needs to ask the right question. The problem is how to find a stock that gives you higher returns than let’s say putting your money in the bank or bonds. What does P/E of 50 tells you? It tells you it takes 50 years to recoup your investment if the earnings stays the same. Reverse that ratio and you get the earning yield, 1/50 = 2%. Is 2% annual returns good for you? Well, the GIC rate in Canada in 2021 is 1.4%. So 2% is still a better investment. But I’m sure you are not satisfied with a flat earnings, no one is. We want the business we invested to grow. Why? Let’s say the earnings is growing at 10% a year, that $2 (from 2% yield) earnings out of $100 will be 1.1 ^ 10 * 2 = $5.19 in 10 years, which means if the price stays the same, the P/E will be 19. If the interest rate stays the same, everyone will want a piece of that P/E 19, and so the demand should push the price much higher, say $259 to keep the yield 2%. So is P/E 19 a good investment in 10 years? Depends on the interest rate and alternative investments. If GIC is 5% in 10 years, I might choose GIC, cause there is no risk. So you see, a good stock needs to have a good earnings yield, or a damn good earning growth rate to justify its current high P/E. So the right question should be, where to find growth? How to predict earnings growth, etc. Forget about all the publicly available information. If the earning growth trend looks good, so will the P/E be very high already. Like Peter Lynch said, look around you, do some detective work. Find out which trend is replacing which, before the numbers show up on the financial statement, or sniffed out by the wall street guys. I remember when I bought the first iPhone, I’m so amazed by it, I told all my friends this is the future. Well, I shouldn’t ignore my 6th sense, and should have back my words with 100K investment in Apple computer. So look for growth, sniff out the trend, and you will find the dream stock to invest. Just beware, others are doing the same too.

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