I’ve talked about earnings per share.
I’ve talked about return on equity.
I’ve talked (plenty) about dividends.
But today, I want to tackle the most popular metric of them all — the price-to-earnings (P/E) ratio.
If a popularity contest were convened for investment metrics, the P/E ratio would trounce the competition.
It is the dominant analytical tool of the profession.
Surveys show that more than 99% of analysts used some sort of multiple, and only 13% used any type of discounted cash flow model.
The P/E ratio is so pervasive that it can even explain the recent bull run in US shares! Just take a recent market update from Charles Schwab’s Liz Ann Sonders:
‘As we turn to the second half of the year, earnings have to step up to the plate to justify the market’s strong run, especially because the entire rally since the trough last October has been driven by multiple (price-to-earnings ratio, or P/E) expansion.
‘It is true that multiples tend to rebound before earnings; but it’s also true that for a rally to be sustainable, earnings need to start showing material signs of strength and contributing to the upside.’
The P/E ratio is democratic and used in investment bank boardrooms and HotCopper chatrooms.
But is it any good?
High P/E bad, low P/E good?
A common refrain from the more conservative investors is that high P/E stocks should be shunned.
In general, high P/E stocks disappoint.
Finance professor Stephen Penman summarised this view in his book, Accounting for Value:
‘There is considerable evidence that the market overprices growth, at least some of the time. High P/E stocks — growth stocks — often disappoint, delivering lower returns than low P/E stocks. The high-price multiples of the late 1990s priced growth that was not realized. Indeed, research indicates that over the last fifty years, firms on average did not deliver the long-term cash flows forecast in stock prices.’
A high earnings multiple is a promise. A promise of strong growth.
But if a P/E multiple gets high enough, the risk of overpromising and underdelivering rises.
Not always, however.
I have just started reading Terry Smith’s book Investing for Growth and came across an incredible chart.
Smith argued that intrinsic value matters: a low P/E stock may have an even lower intrinsic value, for instance.
But a high P/E stock may have an even higher intrinsic value, too:
Terry Smith:
‘However, the level of valuation which may represent good value at which to buy shares in a high-quality company may surprise you. The following chart shows the ‘justified’ PEs (price-to-earnings ratios) of a group of stocks of the sort we invest in.
‘What does that mean? It looks at the period 1973 to 2019 when the MSCI World Index produced an annual return of 6.2% and works out what PE an investor could have paid at the outset for those stocks and still returned 7% p.a. over the period, so beating the index.
‘You could have paid 281 times earnings for L’Oréal in 1973 and beaten the index return. Or a PE of 126 for Colgate. A PE of 63 for Coca-Cola. Clearly this approach would not fit the mutation of value investing in which the rating must simply be low. Yet it is hard to argue with the fact that these stocks would have been good value even on some eye-watering valuation metrics.’
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| Source: Terry Smith |
That’s amazing!
You could have paid more than 280-times the earnings for L’Oreal in 1973 and still beaten the MSCI World Index return over the next four decades.
But just as a high P/E multiple can still represent good value, a low P/E multiple doesn’t always signify a bargain.
Roger Montgomery had a streetcar analogy to make the point, where a low P/E stock is like a VW Kombi and a high P/E stock is like a Formula 1 race car:
‘If a Formula 1 racing car and a VW Kombi are at the starting line of a racetrack, the F1 car will be faster every time. Its average speed will always be higher because it is designed and engineered for speed.
‘You cannot then say that because the VW Kombi currently has a lower speed, it is the car to buy if you want to go fast. That is plainly nonsense. It’s the same with companies and their price-earnings ratios.
‘You cannot say that a company whose shares show a lower price-earnings ratio compared with the average of its peers should be bought because its price-earnings will ‘catch up’ to the others. The VW Kombi will never catch the F1.’
The easy ‘high P/E bad; low P/E good’ axiom is inaccurate. And shows the limits of relying on P/E multiples alone.
You can’t determine a P/E ratio is too high or too low without referring to the company’s long-term prospects.
P/E ratio as an economic cul-de-sac or a window to the market’s thinking?
The utility of the P/E ratio is disputed by many investing and finance heavyweights, practitioners, and professors alike.
Some of the most acerbic criticism comes from investment analyst and prolific author Michael Mauboussin.
In a popular book, Expectations Investing penned with Alfred Rappaport, Mauboussin labelled the earnings multiple an analytical dead end:
‘Since an estimate of earnings per share (EPS) is available, investors must decide only on the appropriate multiple to determine a stock’s value and then compare the result to the stock’s current price and assess whether it is undervalued, overvalued, or fairly valued. The calculation is easy, but the results are disappointing.
‘Since we know last year’s EPS or next year’s consensus EPS estimate, we need only estimate the appropriate P/E. But since we have the denominator (earnings per share, or E), the only unknown is the appropriate share price, or P. We are therefore left with a useless tautology: to estimate value, we require an estimate of value.’
‘Price-earnings analysis is not an analytical shortcut. It is an economic cul-de-sac.’
But if eyes are windows to the soul, P/E ratios are windows to the market’s thinking.
You don’t have to use a P/E ratio to derive an independent valuation of a stock. You can simply use it to figure out the market’s aggregate valuation.
As Stephen Penman wrote:
‘Valuation is not a game against nature, but a game against other investors, and one proceeds by first understanding how other investors think. As an investor, you are not required to establish a valuation, but only to accept or reject the valuation of others.’
If one stock is trading on a P/E multiple of 40 and another in the same industry is trading on a multiple of 10, you have some interesting data on the market’s view on the pair’s relative prospects.
Here, the P/E ratio disparity should kickstart your analysis, not end it.
This is where the intellectual fun begins: do you accept or reject the market’s appraisal of these stocks?
The market is betting the stock trading on 40-times earnings will outperform the one trading on 10-times earnings.
But why?
Are the growth prospects really that disparate? Is the market overestimating the potential of one and underestimating the resilience of the other?
Answering these questions will bear more fruit than simply basing a thesis on how high a P/E multiple is.
Zvi Bodie reiterated this point in his textbook Investments:
‘[The] P/E ratio reflects the market’s optimism concerning a firm’s growth prospects. Analysts must decide whether they are more or less optimistic than the belief implied by the market multiple. If they are more optimistic, they will recommend buying the stock.’
Investing is hard.
But you can use the market’s aggregate thinking to your advantage.
Some read tea leaves; others read charts.
And you can read the market by consulting P/E ratios and the implied growth prospects.
Regards,
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Kiryll Prakapenka,
Editor, Money Morning
