Reblog: How to use the P/E ratio

Valuations are looked at through the prism of cash flows, earnings, corporate governance, return ratios, debt-equity proportion and so on. Within these, the most primary valuation tool used by investors is the Price Earnings (P/E) ratio.

The P/E ratio is arrived at by dividing the stock market price with the company’s Earning Per Share (EPS). For example, a Rs 200 share price divided by EPS of Rs 20 represents a PE ratio of 10. Theoretically, it translated into the assumption that if we were to buy this company today it would take 10 years to earn back our investment.

The Trailing P/E ratio uses the earnings of the last 12 months, while the Forward P/E uses the expected earnings for the next 12 months, which means it requires estimating the forward earnings.

At Mumbai’s Morningstar Investment Conference in October, equity market strategist Ridham Desai and head of Morgan Stanley’s Indian equity research team tackled the subject of India’s high P/E.

The problem with looking at the PE ratio is that earnings is a cyclical variable that fluctuates. If earnings are high, the PE will appear low. Does that mean the market is cheap? Probably not because earnings will then fall.

If earnings are low, which they have been for the past 3-4 years, PE multiples are high. Does that make the market expensive? Probably not because earnings are going to rise.

Since the market is forward looking, the PE is a bad metric to judge valuation.

Read Ridham’s detailed views here

Karl Siegling, Managing Director and Portfolio Manager at Cadence Capital Limited, questioned the use of this tool years ago in a post which has been reproduced below.

1) The biggest and by far the most dangerous component of the PE ratio is that the earnings are the accounting earnings as defined by the accounting standards for a particular country. These earnings are not the cash earnings of the business. In fact, many companies listed on the Australian Securities Exchange (ASX) earn no cash despite reporting profits.

2) A second problem with the PE assumption is that future earnings will be at least what they are currently. In the case of a company trading on a 10 times PE ratio, we as investors are taking a chance that earnings will be at least what they are today for the next 10 years!

Working as an investor in the industry, it is quite clear that estimating the earnings of a company listed on the ASX for a year or two into the future is extremely difficult, let alone 10 years into the future.

3) A third problem with the PE ratio is the idea that 10 times earnings is cheaper than 15 times earnings. The assumption that a company will earn its current earnings for the next 10 years and an investor will get their money back is of course theoretical.

A company’s earnings may well go up significantly or down significantly over the next 10 years. It would follow that we as investors should prefer to own a company whose earnings go up significantly over the next 10 years rather down significantly. The PE ratio has no way of telling us what will happen!

4) A fourth problem with the PE ratio is that it tells the investor nothing about a company’s balance sheet. It may be that a company trading on a 2 times PE multiple is actually incredibly expensive since the company has a very large amount of current debt that it has no way of paying, and as a consequence, the company will be declared bankrupt in the current financial year.

We need only look back to the recent global financial crisis to find many examples of companies in exactly that situation.

5) A fifth problem with the PE ratio is that it tells us nothing about the quality of a company’s earnings. We may look at one company trading on 8 times earnings and declare it cheaper than a company trading on 16 times earnings.

We often hear conversations along these lines. However, upon closer inspection we discover that the company trading on 8 times earnings has just had a one-off profit never to be repeated and that the company on 16 times earnings has displayed 20% per annum earnings growth for the past 15 years.

It may well be that once these factors are taken into account, the company on a 16 times PE multiple is actually a better investment than the company on 8 times.

The list of problems associated with the PE ratio goes on and on. But I have restricted this discussion to what may be the top 5 problems associated with the PE ratio. Let’s promise ourselves that we will never look at the PE multiple again as a serious tool for fundamental analysis.

In a blog post, valuation guru, author and professor Aswath Damodaran, suggested three rules when employing the PE ratio.

A low PE ratio can be indicative of cheapness, but it can also be the result of high debt ratios and low or no cash holdings. Conversely, a high PE ratio can point to over priced stocks, but it can be caused by high cash balances and low debt ratios.

1) When comparing PE ratios across companies, don’t ignore cash holdings and debt.

As the diversity of companies within sectors increases, the old notion of picking the lowest PE stock as the winner is increasingly questionable, since you may be choosing most highly levered company in the sector.

2) When comparing PE ratios across time, don’t ignore cash holdings and debt.

I have noted the ebbs and flows in both cash as a percent of the firm value and debt as a percent of value across time, sometimes due to shifts in the numerator (cash and debt values changing) and sometimes due to shifts in the denominator (market value of equity changing). Whatever the reasons, these shifts can affect the PE ratios for the market, making it look expensive when cash balances are high and debt ratios are low.

3) Any corporate action that changes the cash or debt as a percent of value will change the PE ratio.

Consider a company that has a large cash balance and is planning on using that cash to buy back stock. Even if nothing else changes, the PE ratio for the company should decrease after the buyback, as (high PE) cash leaves the company. Thus, the practice of forecasting earnings per share after buybacks and multiplying those earnings per share by a constant PE will overstate value. This effect will be even more pronounced if the company borrows some or all of the money to fund the buyback since a higher debt ratio will also push down the PE even further.

The original article appears on morningstar.in and is available here.