1/

Get a cup of coffee.

In this thread, I'll walk you through the P/E Ratio.

Why do some companies trade at 5x earnings and others trade at 50x earnings?

When I first started investing, this was hard for me to understand.

So, let me break it down for you.

2/

Imagine we have 2 companies, A and B.

Let's say both companies will earn $1 per share next year.

And both companies will also GROW their earnings at the SAME rate: 10% per year. Every year. Forever.

3/

Suppose A trades at a (forward) P/E Ratio of 10. So, each share of A costs $10.

And B trades at a P/E Ratio of 15. So, each share of B costs $15.

Which is the better long term investment: A or B?

4/

If you had asked me this question 10 years ago, I would have said: hands down A!

After all, both A and B earn the same ($1/share). And they grow at the same rate (10%/year).

But A is CHEAPER than B (10 vs 15 P/E).

So, of course A is the better long term investment.

Right?

5/

The answer is: NOT necessarily.

B -- the MORE "expensive" looking stock -- could *still* end up being the better investment.

Why? Because it's not just about earnings, or how fast earnings will grow.

It's about how *capital efficient* this growth will be.