Real World Investing - Calculating a Stock's True P/E Ratio

This afternoon, as I sat in my office during a thunderstorm, drinking coffee and watching CNBC on mute, I read through the most recent annual report of the Panera Bread Company (ticker symbol: PNRA). The situation was a real-world example of what I described in an article I wrote several years ago, Does a High P/E Ratio Mean a Stock is Overvalued?. There’s no question that the enterprise has a unique concept that doesn’t directly compete with seemingly less healthy fare such as McDonald’s and Burger King Big Macs and Whoppers and given its relatively small size – only 1,024 bakery-café locations as of the end of fiscal year 2006 - but the price-to-earnings ratio seems very rich at over 30x earnings. (And that’s after the stock fell more than 25%, losing a quarter of its market value and punishing stockholders!)

Upon closer look, however, an investor would see that fiscal 2006 was the first year that stock option expense made it onto the income statement as a result of new accounting rules going into effect. That means that the reported increase from $1.65 to $1.84 between 2005 and 2006, or 11.52%, was understated as the real results for 2005, had stock option expense been included at that time, would have been only $1.52. That means that the year-over-year increase in diluted earnings per share was an impressive 21% - or nearly double that reported in the financial statements.

Net Income: $58,849
Depreciation & Amortization: $44,166
Necessary Capital Expenditures: ($20,000)
Working Capital Needs: Negligible due to rapid turnover
Inventory Asset: Not material
Approximation of Owner Earnings:$83,015

That means the adjusted, price-to-earnings ratio if the company were to stop growing, freeing up huge amounts of capital, would be around 21.7x; still not cheap, but certainly much lower than the apparent 30 to 31x you’d see if you glanced at the newspaper or pulled up a stock quote online. There would be some tax adjustments, and pre-store opening costs would evaporate under such a scenario but for our general purposes, those can be put to the side as they wouldn’t be material.

So, is the stock cheap, dear, or fairly priced? That’s something you’ll have to decide for yourself. Remember that it should almost always be in relation to other assets; that is, you can’t decide the stock’s value without taking into account the return you could earn on risk-free Treasury bonds and stocks in general. When the question gets too hard, Charlie Munger and Ben Graham recommended throwing it into the “too hard” pile and focusing on something about which you have absolute conviction.