Does the Price to Earnings Ratio Matter?

Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result. — Charlie Munger

In an interview with Jonathan Davis, Terry Smith of Fundsmith says some companies can be worth paying more for. Smith notes you could have paid 34 times earnings for Colgate and 38 times earnings for Coca Cola back in 1979 and still beat the S&P 500 index over the next 30 years. Investors, who have what the article states as an “attack of the vapours” when the P/Es of their stocks get to 20 would have missed out on Walmart, which was trading at 277 times earnings.

In a blog post titled Thoughts on Return on Capital and Greenblatts Magic Fromula Part 2, John Huber puts it this way: “Munger is right… imagine buying Walmart in the 70’s, Fastenal in the 80’s, etc… You could have paid 50 times earnings, and your long term results (if you held from then until now) would likely come close to the returns on capital those businesses have produced over time (near 20% over time).”