Electronic Data Systems grew its sales and profits while its shares fell from forty dollars to three by nineteen seventy-four. Peter Lynch had read an analyst's report defending a price of five hundred times annual earnings. A successful company could not grow enough to justify what buyers had paid.
That is the danger in buying a great business without asking how much greatness the price already assumes. Lynch starts by translating the price into the profits it requires. Then he checks whether those profits are plausible, whether the accounts describe the business fairly, and what will actually belong to each shareholder.
What would the company have to earn?
Multiply the share price by the number of shares to get the market value of all the company's equity. Earnings are profit after expenses and taxes. Divide the share price by annual earnings per share and you have the price/earnings ratio, or earnings multiple. Ten times earnings means paying ten dollars for each dollar of annual profit. It promises no repayment date. The company may keep those profits, and future earnings can change.
In his millennium introduction, Lynch invents DotCom.com to work backward from a hoped-for gain. Its shares give it a total market value of ten billion dollars. For an investor's money to grow tenfold, with the share count unchanged, that value must reach one hundred billion. Suppose investors still pay a generous forty times annual earnings then. Divide one hundred billion by forty. The company would need two and a half billion dollars in annual profit.
The arithmetic supplies a demand the business has to meet. Can it reach enough customers to earn that much? Lynch looks for an identifiable route: lower costs, higher prices, new markets, more sales in existing markets, or fixing or selling a losing operation. Expanding profits need not mean building more factories. But something has to explain the improvement beyond the hope that buyers will pay more for the shares.
There is no earnings multiple that makes every purchase sensible. Compare it with similar businesses, the company's own history, and realistic growth prospects. Interest rates and enthusiasm also change what investors pay. A low multiple cannot rescue mediocre prospects; slight overvaluation alone need not justify selling an exceptional grower you already own. Even rising earnings can disappoint if buyers expected more. When earnings fall and investors also pay less for each dollar of them, the share price suffers twice.
What is behind the profit?
Before trusting the earnings figure, find out what changed it. A one-time charge can reduce reported profit and make the earnings multiple look unusually high. The charge may recognize a real loss, or accompany closing an unprofitable operation that leaves a better business behind. In the book's historical accounting examples, charges also reduced the recorded value of franchises that could remain valuable. An accounting reduction deserves investigation; it is not automatically harmless.
Inventory can give an earlier warning. Goods piling up faster than sales may eventually need markdowns, damaging profits that currently look healthy. Even the method of assigning costs matters. Charging an older, cheaper batch of goods against a sale produces more reported profit than charging a newer, expensive batch. The customer pays the same amount either way.
Cash has its own complication. Lynch's fictional Pig Iron brings in money but must spend most of it keeping its furnaces competitive. Stop spending and better-equipped rivals take its customers. What matters to owners is the cash left after necessary investment. A business can report impressive cash flow while leaving little available to distribute or put into additional growth.
What remains for each share?
Assets need the same scrutiny. Old land may be worth far more than its recorded cost. Obsolete machinery or unwanted goods may fetch far less. Shareholders own what remains after liabilities, and the debt survives even when an asset's value collapses. Pension shortfalls and legal claims can consume that remainder too. If those claims cannot be estimated, the apparent bargain may be impossible to value.
Compare debt with the owners' recorded stake, and check whether cash is growing or shrinking relative to debt. Repayment timing matters. A lender demanding money soon can end a recovery before it arrives. Debt due years later can buy time, provided the company meets its obligations. An attractive future means little to an owner whose company cannot finance the wait.
Then follow the money. Dividends pay part of earnings to shareholders; retained profits may finance worthwhile growth. Management can also waste spare cash on overpriced acquisitions. More cash does not settle how much the owners will benefit.
Finally, count the shares. Repurchases increase earnings per remaining share if total profit stays unchanged. Issuing more shares spreads the claim more widely, so a company can recover without restoring its old shareholders' fortunes. A stock split merely divides the same ownership into more units; it creates no wealth.
The price worth paying depends on this whole account of the business. DotCom.com's required profits become a useful test only when you can explain how it might earn them, keep enough cash, and deliver value to each share. A confident growth forecast has to survive those questions.
Three things to keep
Work backward from the price to the profits it requires.
Reported earnings and cash available to owners can tell different stories.
Check the claims ahead of shareholders and the number of shares dividing what remains.