If you’ve been investing for even a little while, you’ve probably come across the Price to Earnings (P/E) ratio, which is a common valuation metric for pricing shares. An ?average? price to pay for companies in the S&P/ASX200 (INDEXASX: ^AXJO) (ASX: XJO) is around 16 times earnings ? that is, shares cost around 16x the amount of profit that a company earned last year.
Really popular or high-quality companies like CSL Limited (ASX: CSL) or a2 Milk Company Ltd (Australia) (ASX: A2M) can command P/Es of 20-30x, or even as high as 50+. Other companies can go as low…
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If you’ve been investing for even a little while, you’ve probably come across the Price to Earnings (P/E) ratio, which is a common valuation metric for pricing shares. An ‘average’ price to pay for companies in the S&P/ASX200 (INDEXASX: ^AXJO) (ASX: XJO) is around 16 times earnings – that is, shares cost around 16x the amount of profit that a company earned last year.
Really popular or high-quality companies like CSL Limited (ASX: CSL) or a2 Milk Company Ltd (Australia) (ASX: A2M) can command P/Es of 20-30x, or even as high as 50+. Other companies can go as low as 6x or 8x earnings. However, the next example of the power of compounding over the ultra-long term can make a mockery of the P/E valuation metric.
Sydney-based fund manager Peters MacGregor posted a tweet on social media recently that many investors may find astonishing, which I share with their permission.
You could have bought Walmart for 1,902x earnings, and still made 100x your money
According to their data, which they provided for verification, you could have bought US retail giant Walmart at its Initial Public Offer (IPO) – in 1970 – for 1,902x its earnings (adjusted for stock splits), and still earned a 10% Compound Annual Growth Rate (CAGR) since then – before dividends.
(CAGR simply means that the 10% compounds on top of itself. E.g. $1 becomes $1.10, which becomes $1.21, etc.)
For illustration, $10,000 growing at 10% will become more than $1 million (100x your original investment) in 49 years. Walmart has been around for 47 years and including dividends it blew past that milestone a while ago.
I thought there were a few observations we could draw from this example:
- Not one single investor would have looked at Walmart in 1970 and said ‘I can buy this for 1,902x earnings and still make an absolute killing over the next 47 years’
- At the time it launched, Walmart had a market capitalisation of $5 million (in 1970s dollars) and was a minnow flying below investor radars
- There wasn’t more than a handful of household investors who held the company for the entire time
If we turn these on their heads, there are some useful investment lessons:
- The biggest long-term winners will always surprise you with how much they are capable of winning by. There are plenty of examples out there of The Coca-Cola Company and Berkshire Hathaway (Buffett), for example, defying valuation and forecasts. Famed fund manager Peter Lynch was often quoted as saying his biggest winners were a surprise.
- You can buy these companies well after they become successful and still make a lot of money
- The biggest growth opportunity is when a small company is rolling its model out universally
- Time is your best asset when you own a growing business
Unfortunately on the ASX, we are a little limited in our choice of growth companies. Walmart had a potential 205 million customers in 1970…Woolworths Limited (ASX: WOW) today has 24 million.
However, some smaller companies like Retail Food Group Limited (ASX: RFG), A2 Milk, and even some medium-sized ones like XERO FPO NZX (ASX: XRO) have products that they are taking to the globe, and could become much larger over time.
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Motley Fool contributor Sean O'Neill owns shares of A2 Milk, Retail Food Group Limited, and Xero. The Motley Fool Australia owns shares of A2 Milk, Retail Food Group Limited, and Xero. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.