AppleTreesandExperience 95the apples at prices below what people woul dbe willing to pay an d
that you coul draise the price without re ducing your sales. Also,
there are treatments, you know, that coul dbe applie dto increase
the yiel dof the tree. This tree coul dhelp spawn a whole orchar d.
Any of these woul dincrease earnings.”
“The earnings also coul dbe increase dby lowering costs of the
sort you mentioned,” the old man continued. “Costs can be reduced
by speeding the time from fruition to sale, managing extensions of
credit better, and minimizing losses from bad apples. Cutting costs
boosts the relationship between overall sales an dnet earnings or, as
the financial types say, the tree’s profit margin. An dthat in turn
woul dboost the return on your investment.”
“I am aware of all that,” she assure dhim. “The fact is, we are
talking about risk. An dinvestment analysis is a col dbusiness. We
don’t know with certainty what’s going to happen. You want your
money now, an dI’m suppose dto live with the risk.
“That’s fine with me, but then I have to look through a cloudy
crystal ball, an dnot with 20/20 hin dsight. An dmy resources are
limited. I have to choose between your tree and the strawberry patch
down the road. I cannot buy both, and the purchase of your tree
will deprive me of alternative investments. That means I have to
compare the opportunities an dthe risks.
“To determine a proper rate of return,” she continued, “I looked
at investment opportunities comparable to the apple tree, particu-
larly in the agribusiness industry, where these factors have been
taken into account. I then adjusted my findings based on how the
things we discusse dworke dout with your tree. Base don those ju dg-
ments, I figure that 20% is an appropriate rate of return for the tree.
“In other words,” she concluded, “assuming that the average
earnings from the tree over the last three years (which seems to be
a representative period) are indicative of the return I will receive, I
am prepare dto pay a price for the tree that will give me a 20% return
on my investment. I am not willing to accept any lower rate of return
because I don’t have to; I can always buy the strawberry patch in-
stead. Now, to figure the price, we simply divide $45 of earnings per
year by the 20% return I am insisting on.”
“Long division was never my strong suit. Is there a simpler way
of doing the figuring?” he asked hopefully.
“There is,” she assure dhim. “We can use an approach we Wall
Street types prefer, calle dthe price-earnings (or P/E) ratio. To com-
pute the ratio, just divide 100 by the rate of return we are seeking.