Understanding the P/E ratio
Valuation series: Chapter I
The value of a company is fundamentally determined by its prospective cash flows, given that stock price and future dividends hinge on these cash flows. Consequently, a Discounted Cash Flow (DCF) model appears to be the most rational tool for valuing companies. Nevertheless, in numerous instances, analysts and investors resort to using multiples rather than employing the DCF model. Among these multiples, the Price-to-Earnings (P/E) and Enterprise Value-to-EBITDA (EV/EBITDA) ratios reign supreme within the investment industry.
Today, our focus is on the timeless P/E ratio, the most extensively utilized metric in the realm of public equities.
Why is the P/E ratio widely adopted in the industry?
There are several reasons why the P/E ratio is pervasive in the investment industry.
Firstly, the P/E ratio is a straightforward metric with a simple calculation. Earnings per Share (EPS) is a widely reported and readily available metric, making it exceptionally easy to employ. Although it can be a valuable metric, it is a common practice to use it as a shortcut when evaluating a company.
A common pitfall is valuing a company by taking current or projected EPS and applying a multiple, without comparing the resulting valuation with other tools. Moreover, markets anticipate future prospects; hence, a company might trade at low multiples, reflecting a projected decline in earnings—a value trap—where investors believe they are purchasing at a discount, but in reality, the opposite is true. For instance, if a company presently has an EPS of 1.0 and trades at 8.0x earnings (i.e., a price of 8.0), the stock might seem inexpensive. However, if the EPS drops to 0.5, the implied multiple would be 16x. This is an exagerarte example, but I see many people buying a stock because it trades at, for example, 12x vs. historical average of 15x. This is not a good decision if we don’t understand why the stock trades at 12x.
Estimating earnings is considerably more straightforward than estimating cash flows, as it necessitates fewer assumptions. When calculating cash flows, one must estimate changes in working capital, the company's investment needs, cash taxes, and so forth. Therefore, many people resort to P/E ratios as calculating cash flows is a daunting task. I believe individuals should combine different valuation metrics, as this acts as a cross-verification.
A common oversight
A frequent mistake made by retail investors is to log into their data provider, extract the EPS estimate of a company, and apply a multiple without substantiating that multiple with supporting assumptions. For example, if I were to log into my Tikr.com account now, I could observe that 3M (MMM) is trading at $88 per share, with estimated EPS for 2024 and 2025 ranging between $9-10. This would imply a P/E multiple of 8.8-9.8x. It might appear cheap, but we should scrutinize the financials and be capable of answering fundamental questions such as:
After two years of declining sales, why are sales expected to rise next year?
What rationale exists for expecting margins to revert to pre-covid levels?
What is the market penalizing in its valuation?
By the way, the stock seems inexpensive, and I will delve into it!
Just as you wouldn't purchase a house solely based on its price, it's imperative to consider other factors such as its location, the prices of neighboring houses, the house's condition, and more. However, many retail investors skim through some news about a stock and buy it simply because it seems inexpensive based on projections by research analysts, without conducting further research. Subsequently, if the stock price rises, they categorize themselves as profitable investors, but if it falls, they view the market as a casino.
For this reason, it's crucial to avoid shortcuts with P/E ratios and take into account various other methodologies. Conduct thorough research before making an investment. If this seems complex or uninteresting, it is better to invest in an index through an ETF and let time compound the interest. The P/E ratio is a good measure, but it should be analyzed in conjunction with other valuation tools.
Primary issues with the P/E ratio
Think in terms of cash instead of accounting earnings!
The P/E ratio chiefly grapples with one issue: the 'E' or earnings. Firstly, earnings are not equivalent to cash flows. Secondly, which 'E' should one use? The current earnings? Last twelve months (LTM) earnings? Projected future earnings?
Earnings are not equal to cash flows
1. Capital Expenditure (Capex)
The investments made by a company to sustain or grow the business are recorded as assets and are amortized over time. This has several implications: On the earnings side, the investment will be amortized (i.e., expensed) over a period of years. On the cash flow side, the investment will appear directly as a cash outflow.
If a company anticipates significant capital expenditures in the ensuing years, EPS will underestimate the real cash needs of the company.
2. Working Capital
The earnings of a company (net income) take into account the accrued revenues and expenses of the period. However, it is commonplace for growing companies to witness an increase in receivables, inventories, and payables.
Receivables: When companies sell a product, they might not collect the cash immediately. If receivables increase (an asset on the balance sheet), the company will have collected less cash. For example: A company records $100 of revenue and an increase in receivables of $10. The earnings will account for $100 of revenue; however, the cash collected will be $90.
Inventory: Investments in inventory are recorded as assets. Once the product is sold, its cost appears on the Profit & Loss statement as Cost Of Goods Sold (COGS). If a company has invested in inventory, it won't appear in net income; however, the company will have employed more cash than the expense recognized in the P&L. Once again, the earnings will understate the actual cash outflows.
Payables: Payables reflect the amounts owed to suppliers. A supplier may provide goods or services that will be recorded as an expense in the earnings, but the company may pay the suppliers 30 days later. Here, the company will have more cash; therefore, COGS and Opex will be higher than the cash expended. In this scenario, earnings will be lower than the cash flow.
In conclusion, working capital can be a significant source or use of cash. Net Income does not account for cash inflows and outflows.
3. The P/E ratio doesn't account for the cost of capital
When discounting cash flows, we utilize the Weighted Average Cost of Capital (WACC), an average between the after-tax cost of debt and the cost of equity. However, when applying a P/E multiple, it does not factor in the company's cost of capital. Although the P/E multiple can be adjusted for high leverage, this adjustment is imprecise, and investors often make approximate adjustments, adding or subtracting round numbers (e.g., from 10.0x to 9.0x).
Beware of the PEG ratio! This ratio posits that a stock is attractive if its P/E is lower than the expected 5-year EPS growth. However, as this ratio is based on the P/E, it inherits the same issues as outlined above. Furthermore, it may not be applicable in some situations: E.g., A company with a stock price of $100 is trading at 10x. If suddenly the stock drops for no apparent reason, trading at 7x, and the predicted EPS growth is lower than 7, it would not be attractive according to this ratio. Hence, at times, it may not make sense.
EPS * Multiple = potential value
In conclusion: While the P/E ratio is a common tool due to its simplicity and directness it is vital to remember that the value of a company is determined by its future cash flows. Earnings (i.e., net income) may not be an accurate proxy for cash flows in many cases, as earnings do not consider changes in working capital and capex needs. Therefore, the P/E ratio should be employed in conjunction with other valuation tools, such as a DCF. If used in isolation, caution is necessary regarding the accounting problems before making any investment decisions.
What are your thoughts on P/E? Share it with me and lets improve our valuation techniques!