The Devil's Deal

67An equitable solution

‘Normally a low P/E ratio suggests a value company. Solid and

dependable, but the share price is never going to zoom.’

Value, growth, neither, both

Jerry showed me a table with two companies.

Lucky Star Bet is a gambling company which had recently

launched a very popular collection of spread bets on football.

Gamblers could put their money on the exact time a goalkeeper

rst took off his gloves or the number of times the ball hit

goalposts. The company spent a fortune in advertising and had

made a heavy investment in computer systems and software.

Lucky Star Bet had just reported its rst earnings of 10p per share.

Great Northern Power supplies gas, electricity and water to

consumers in the north-east of England. The company had been

running since 1953. Its EPS was also 10p per share.

The strange thing was that Lucky Star’s share price was 400p and

Great Northern’s was only 100p. Why were shares that made the

same earnings priced so differently?

Lucky Star Bet Great Northern Power

Share price 400p 100p

EPS 10p 10p

P/E ratio 40x 10x

Why were investors willing to pay well over the odds to buy

companies like Lucky Star? The hope was that next year’s EPS

would be 15p, and then 25p and then maybe 50p as it became a

dominant player in the market. If this happened the share price

would zoom and the investors will be rewarded with big capital

gains.

‘That’s absolutely crucial,’ Jerry continued. ‘A high P/E ratio is

something which the market ascribes to a high-growth company.

Welcome to the jungle68

The greater the expectations of growth in earnings, the higher

the P/E.

‘With good old Great Northern Power, investors expect the

earnings next year to be 10p, maybe 9.5p or maybe 10.5p. It’s

the sort of company that isn’t going to have a massive change in

earnings either way. It’s steady.’

The Google growth story

Google funded its expansion via an issue of shares priced at $85.

The company’s EPS at the time was $1.14, so the P/E ratio on

listing day was 74.6x (which is $85 divided by $1.14). Over the

next six months, the shares soared to $185, which meant that

the P/E was a massive 162.3x ($185 divided by the same EPS of

$1.14).

(Please note that it’s common practice to calculate the P/E to

one decimal place and to follow it with the ‘x’, which is analyst

shorthand for ‘multiple’.)

Why were investors prepared to buy shares at such a massive

premium? Because they believed that Google could massively grow

earnings.

Google is the world’s most visited website. Stop for a second

and just consider how important that makes the company. The

acquisition of DoubleClick meant that Google was the first

company to make proper profits from online adverts, which have

now superseded traditional media adverts. Continual spending on

research and development keeps driving people to the company’s

websites. Buying YouTube, the world’s third most popular website,

was another revenue-enhancing masterstroke.

Have you ever heard anyone say ‘I Binged him’ or ‘I Yahooed her?’

No, of course you haven’t. Google belongs to that select group of

companies – Hoover, Xerox – whose name has become a verb.

case study