It happens all the time.
New investors get introduced to the stock market, learn a couple of financial ratios, and go diving into the market thinking they’re king of the hill only to return from their investing dive mauled with scars from the sharks they did not anticipate or the harsh scrapes of corals on their backs.
They might have a fish, or they might not, but either way, they could have avoided such unpleasant situations by being more educated about some of the ratios they use – and the price to earnings ratio is one such metric.
All too often, we see people placing too great an emphasis on the Price to Earnings Ratio. A little knowledge is dangerous, for it instils unfounded confidence in the hands of an amateur.
Just as you would not enter into a knife fight with a master of the knife arts without years of training, you should not invest in the markets with merely a rudimentary understanding of how the PE ratio works and all of its intricacies.
This article aims to upgrade the novice investor who might mishandle the PE ratio, to a savvy, nuanced investor, who better understands how to use the PE ratio to garner greater profits and avoid losses.
#1 Don’t Be Lured By Low Price to Earnings Ratios
Let’s start by acknowledging the elephant in the room.
A low price to earnings is good. But it should not be the sole consideration like so many have claimed.
In 1976, Benjamin Graham, the father of value investing and the mentor of Warren Buffett made a simple declaration, backed by evidence, found both during and after his lifetime, that changed the course of investing as you probably know it today.
Graham’s proposed investment approach was that an investor should hold no less than 30 stocks, with a price to earnings ratio of less than 10, and a debt to equity ratio of less than 50%. The investor should then hold these stocks until they return 50%, or failing which, sell it 2 years regardless from the date of purchase.
While Benjamin Graham’s strategy worked in the 50 years prior to 1976, researchers were sceptical it could work moving forward in different environments and with the proliferation of technology.
That is why they tested it.
And what they found surprised them.
Benjamin Graham’s seemingly brain-dead strategy was found to have outperformed the S&P 500 from 1976 onwards to 2010, displaying above-market returns throughout all of the great turmoils we have faced in the 20th century.
- Benjamin Graham’s approached turned $100 invested in January 1st, 1976 into $36, 354 by December 31, 2011. An average compounding rate of return of 17.85% per year.
- For comparison, the S&P 500 turned $100 invested over the same start and end timing, into a mere $4,351 – a compounding rate of return of 11.05%.
It is little wonder then that most investors are lured by Low Price to Earnings Multiples.
Hunting stocks with low price to earnings multiples is not a bad thing to do. The emblematic, and problematic part of all this is that investors have somehow seemed to forget the crucial other parts of Graham’s strategy.
- To require a debt to equity of less than 50%,
- To hold until the companies have returned 50% and then sell them, or,
- To sell after a holding period of no more than two years from the purchase date.
This whole back part of the strategy seems to have been thoughtlessly misplaced on the endless hunt for a low price to earnings multiples.
Somewhere, somehow along the way, investors seem to have lost their heads.
I liken this to rowing a boat on a lake and watching a beautiful mermaid swim up to you, enticing you with whispers of bliss and fulfilment.
Your logical head fails to function as you lean in, dreaming of selling this cheap stock for triple what you paid and taking up a classy holiday in the French Riviera as you dump your investment capital in.
And then as you lean in, this happens.
And this is the moment you realise that the mermaid’s about to have your head for dinner just like the stock market is going to take your Retire-To-The-French-Riviera Money because you hunted on the basis of a low Price-to-Earnings multiple.
Takeaway: Price to Earnings is best analogized as a person’s salary. You wouldn’t own a person based on their salary without ensuring they don’t owe a mountain of debt.
You also don’t want to own a person who always overspends on their monthly hobbies lumpily. The same is true of companies. You want to own well run companies, with low debt, and good cash flow. Anything else is unacceptable.
#2 Problems With Earnings
Beyond mermaids taking heads and investors being lured with low price to earnings multiples, the earnings of a company itself is…just not a clean metric to go by.
Let me use a simple analogy to explain what I mean by “not clean”.
Imagine a working man as a company. His salary is his earnings. Take his salary, minus his expenses, bills, new shoes, new business course, or whatever else he might need to remain competitive in the workforce and what is left is his…savings – otherwise known as free cash flow for a company.
Now let’s imagine that there are two such salary workers, Tom & Jerry.
They both earn $10,000. The Price to Earnings multiple at this point in time would show that they are both similar.
But Tom might spend $4,000 a month flying all over Asia to secure deals and earn that salary of $10,000 whereas Jerry simply works at a local office.
The difference?
Jerry has $4000 more free cash flow compared to Tom.
And the Price to Earnings would not have reflected that in the slightest.
Investors who look purely at earnings would not be able to differentiate between a high quality “company” like Jerry versus a lower quality “company” like Tom.
If you want to have a look at a clean metric, look at the price to free cash flow of the company instead.
Takeaway: Earnings is not reflective of the true value of the company. Rather, it is simply a measure of how expensive or cheap it can be in relation to its peers. If two businesses are operating in the same sector and are similar in all other aspects with the exception of their price to earnings, you should in almost all cases barring extraordinary accounts pick the stock with the lower price to earnings.
#3 The Quality of Earnings Should Be Considered
Earnings are probably the most tangible measure of value creation for a shareholder. Higher earnings almost always lead to higher share prices which always leads to happy shareholders.
- But can you simply trust the earnings provided by a company?
- Beyond the price of earnings, what else can be inferred from a company’s earnings?
- Is it possible to tell if a company is advantaged or disadvantaged from its competitors?
Quality of earnings answers all of these questions.
Formula: Quality of Earnings = Operating Cash Flow / Net Profit
Operating cash flow is the total sum of all cash flowing in and out of the business. And net profit is…well, the total profits.
From a logical point of view, Operating Cash Flow should always be more than Net Profit. Just like your salary is always more than your savings.
Not the other way around.
This is why it is so critical to understand Quality of Earnings as an example, and why we actually went to the trouble of having it displayed under our company data page for stocks.
As a rule of thumb, we want a company’s quality of earnings to be within the normal range for the business it is in.
What on earth do I mean?
Here’s an example.
- If you are a Grab driver, you provide the service, and the passenger pays Grab – not you.
- As a driver, you receive your cash on a periodic basis. Perhaps its once a week. Twice a month. Or once a month.
- That means that as the driver, you have to fork out cash in rental, maintenance, and petrol on the daily basis. You can’t drive to the petrol kiosk and say “Hey look, I delivered 20 passengers today! Just let me pump patrol la!“.
- The attendants will laugh you off. Cash talks.
- Companies with low quality of earnings typically receive their cash later for a service or product delivered first. In the above screenshot, OKP Holdings is a construction company. It delivers the product and collects payments in milestones reached. Obviously, it would have a poor quality of earnings.
- A chicken rice stall, on the other hand, would experience a better quality of earnings. Cash is paid in return for the food prepared.
- Technology companies would probably have an outstanding quality of earnings. Payments are often instantaneous for a service that was already set up and running. Or perhaps even paid in advance for services or products yet rendered!
In other words, the quality of earnings for a company should be reflective and used as a yardstick for the company business compared against its peers.
- Two chicken rice stalls of the same size and scale with the same net incomes should have similar quality of earnings.
- Two construction companies of the same size and scale with the same net incomes and receiving payments similarly should have similar quality of earnings.
- If one has a lower quality of earnings persisting throughout the years as compared to its peers where nothing else appears amiss, its usually a sign of a weaker business model. Avoid investing in such companies.
P/E Ratio should always be considered together with Quality of Earnings.
#4 Earnings Persistence and Consistency Is Key
So the stock has a low price to earnings. Low debt. Great free cash flow.
Now what? Can you invest?
The answer is still no!
You have probably looked at one year’s worth of financial statements. Now go look at the past 5 years’ worth of financial statements and find out how persistently the company has been able to generate the earnings it commands today.
Paint the picture. See the company’s past. See how consistent it has been.
Why?
In business, there are the main recurring operations and the non-core or non-recurring operations.
Relying on unadjusted earnings to forecast its growth rate would be disastrous. Take a look at the financials of Sunningdale Tech, after deducting the one-off adjustments.
We can see that instead of a 36.3% improvement Q on Q, the adjusted profit actually fell 83.8%!
This would have led the unsuspecting investor looking purely at earnings to calculate a much lower P/E Ratio.
Investors need to adjust for one-off events and timings and value persistence of earnings over one-time earnings spikes. The money is made on the companies with strong long term earnings throughout all kinds of business cycles. Such businesses are capable of multiplying or compounding company value, and therefore shareholder value.
#5 P/E As A Whole
The most common misconception when using P/E Ratio is that 10x earnings is always cheaper than 20x earnings.
That is blatant nonsense.
When using this ratio, the investor must consider other factors such as the future growth of a company or if the company is facing trouble in the near future.
Look at Singapore Press Holdings (SGX:T39), its P/E Ratio has declined from a high of 25x to 13x currently.
Does this compression mean that this company is getting cheaper?
The paradigm shift in the media industry has resulted in the decline of SPH’s revenue and profit.
As investors realise that their problems are here to stay in the near to mid-term, the share price will continue to suffer as a result.
On the other hand, we have seen special cases where investing in low P/E companies can reap huge rewards.
An example would be Monish Pabrai’s famous investment in Fiat Chrysler when it was trading at US$8.
He forecasted that the Fiat’s management would grow earnings to about US$4.50 per share in 2018 which will translate to about a P/E ratio of 2 at current prices.
In addition, the management will be spinning off some of their business to unlock value for shareholders.
Thus, Monish Pabrai’s “heads I win, tails I don’t lose much” strategy has enabled him to earn a huge payoff, and by 2021, he would be able to recoup his entire investment through dividends paid out from the company alone.
#6 The Alternative to P/E Ratio: Enterprise Value
Just because a stock is cheap at face value does not mean you should buy it. However, this does not mean that valuation ratios do not have its place in valuing stocks. To avoid the fallacies of taking price and earnings straight from financial statements, here is an alternative ratio that you could use.
- Enterprise Value (EV) / Earnings Before Interest & Tax (EBIT)
One way to consider cash and debt is to look at ‘Enterprise Value’ instead of Market Capitalization where;
- Enterprise Value = Market Capitalization + Total Debt – Total Cash & Cash Equivalent
Let’s take a look at the table below for a better understanding.
The conventional P/E ratio would value all 3 companies at 10x while using EV would price in debt and cash, resulting in a more insightful valuation.
For net income, we would use the company’s Operating Profits, or EBIT, in order to strip away all one-off items and only looking at the company’s main recurring business operations.
EBIT provides a better view of the company’s financial health by removing capital investment, financing variables and only accounts for necessary expenses to keep the business running.
Summary
We have covered the reliability of the P/E ratio and what they exactly represent. By now, it should be clear that investing in stocks based on P/E Ratio is not a sound strategy.
While it can be an early indicator of some sort to suggest that a stock may be a steal, investors should take the time to fully understand the business before considering its valuation.
In value investing, we should not base our thesis on valuation alone.
Price is not value.
We should not focus on price first and business quality later.
For final thoughts, I would like to leave you with this article by Polen Captial title “Wonderful Companies at Fair Price” which studied the relationship between strong earnings growth and P/E Ratios and how it affects future P/E ratings.
“We spend far more of our time understanding the earnings potential of a business rather than trying to determine its fair value. Strong earnings growth is not only indicative to us of a potentially great business, but of a business that may be able to protect investor capital through a range of financial and economic circumstances.”
Cheers.
