In The Intelligent Investor, Graham argues for staying away from growth stocks by setting an upper limit on the Price-Earnings ratio you’re willing to accept. In other words, set a limit, such as 25, that no investment you make will exceed.
The reasoning behind this is rooted in a fundamental understanding of what the PE ratio actually is: the number of years it would take to get your money back if earnings stayed the same. At a PE of 25, you’re betting that either the company’s earnings will stay flat for the next 25 years (extremely unlikely), or that earnings will double, or more, so you get your money back in a shorter amount of time.
Either way, you’re betting on a future that doesn’t currently exist. That’s okay. Betting on the future is, in essence, what investing is. But setting a limit on the PE ratio you’re willing to bet on a stock forces you to act with humility and stops you from making too big a mistake.
Connections
High Prices Are The Primary Source Of Risk
Link Explanation: Ultimately, both the linked note and the current note stem from the teaching that when you invest in a business, you are doing just that, becoming an owner of the business. It is not a lottery ticket. It is a business, and when you view it from that perspective, the takeaway is that the price of the stock can vary significantly, but has little to do with the ability for the business to generate money. The price however matters greatly, for whether you as an owner are able to get your money back. If you buy at too high a price, and the earnings do not grow, or worse shrink, you will be waiting a very long time to see the free cash flow from your investment.