Let’s suppose that there is company A trading at a stock price of $15 per share. On the other side, there is company B priced at 30$ per share: Which company would be the better investment?
Based on that information alone, the answer is that we can’t tell. There simply aren’t enough details for us available to redeem one investment superior to the other. So what’s missing? What information about a stock and the company behind it do we need to make a reasonable call?
From the view of a fundamental investor, important information to look at, could be all the valid answers related to the very simple question: “How much money does the company make?“.
"You must thoroughly analyze a company, and the soundness of its underlying businesses, before you buy its stock"
There is a variety of perspectives from which this question could be adressed:
- The revenue that the company earns from its operations
- The net profit earned after subtracting all associated costs
- The real cash flows that have been made after adjusting for accounting principles
- The return on invested capital that represents the firm’s efficiency
So if we take the current price of a company and relate that to a standarized fundamental figure such as earnings, what we get is a relative valuation metric like the P/E ratio.
Defining the P/E Ratio
The price-to-earnings ratio also known as the P/E ratio can be used to determine the relative value of a stock. It essentially tells us how much money we would be currently paying for a stock in relation to its earnings.
While there are all sorts of relative metrics, which help you evaluate a company, the P/E ratio is probably the most widely used one. This article explains how to calculate the P/E ratio, the usefulness of it, and why the P/E can also be misleading while analyzing businesses.
Calculation
The price-to-earnings ratio of a company is calculated by dividing its price per share by its earnings per share. The earnings-per-share (EPS) is the total net income of a company divided by its shares outstanding.
If a stock is currently priced at $40 and its earnings per share for the year is $5, the P/E Ratio would be calculated by dividing $40 by $5. That would equal a P/E of 8.
Generally speaking, people decide to become active investors with the hope to generate higher than average returns in the long-run. The very basic premise for that acccomplishment is to assess companies that are deemed as undervalued and sell them when they’re overvalued.
On a theoretical level, as investors, we would prefer to buy companies at a lower PE ratio (if everything else being equal). That is because based on the earnings power of a business alone, it is always better to pay less for more earnings power. On the other hand, paying more for a company that makes less money (i.e. that has a high P/E ratio) would be considered a bad deal, and we would be worse off.
Is it really that simple?
So what does that mean in practice? Is buying companies with low P/E ratios good because they’re undervalued? And doesn’t selling companies with high P/E ratios seem valid since they’re overvalued?
Throughout the past, there have been many investors who have tried this approach before. In fact, that is essentially considered by many as the core of value investing. Ben Graham — the father of value investing — has outlined his approach of screening companies to fit certain fundamental characteristics.
The point is that even if such strategies would work consistently across several cycles of market up and down turns, it would still be too uncertain and illogical to conclude the value proposition of one specific company based on a price-to-earnings ratio.
The problem is that in practice, there are various other fundamental factors that we need to account for. That’s because markets are much more complex than a simple implication coming from the P/E ratio. There has to some reasoning behing stocks that are trading at a higher P/E ratio than others. And trying to understand that particular reason will give us a much deeper and more pronounced idea about the true intrinsic value of a stock.
Clearly, other investors (specifically those who determine prices)
Shortcomings of the P/E Ratio
The P/E Ratio Doesn’t Assess the Future
The P/E ratio is determined by the past EPS of a company. There is no reason given, why earnings should be expected to grow or even stay the same in the following years just by looking at the current P/E.
That’s because long term prospects and other important indicators such as growth are entirely uncovered by the P/E ratio. The price multiple only indicates what investors would have to pay for the recent earnings of a business if they would buy the stock for the current given price.
Most companies, which look underpriced by their P/E often have a reason why the market values them in that way. When investors expect companies to grow massively within the next few years, they are willing to pay a premium for the business, resulting in a higher P/E ratio.
On the other hand, when a company becomes unfavorable in the eyes of the market due to negative factors such as recent incidents within the business, declining earnings, or poor long term prospects, its stock price is likely to decline, resulting in a lower price multiple. Therefore, a low P/E ratio doesn’t automatically indicate a good company trading at an undervalued price.
Evaluating the current situation and assessing the reasons why a stock is trading at the current P/E level can be crucial in order to prevent bad investment decisions.
Cyclical Stocks Are Common Value Traps
When cyclical companies reach the peak of their business cycle, their price-earnings multiple is oftentimes likely going to be low as a result of increased earnings. This could lead many investors to the conclusion that it’s a good time to buy the stock due to the uncommonly low price multiple. Especially when the problems mentioned above don’t even occur, and the fundamentals of that company look great on paper.
In reality, that exact moment would be the worst time to buy due to the nature of the business cycle in which the company operates. After the peak of its cycle, the earnings of that stock are about to contract significantly, as the business drops back down to the bottom of the cycle.
Investors would have been losing money at that point, just because they saw a seemingly excellent buying point of what turned out to be a value trap of a cyclical company. This may happen often if investment decisions are mainly based on an ‘attractive’ P/E Ratio. Using other valuation metrics like the CAPE ratio would have eventually prevented that outcome.
Earnings Can Easily Be Manipulated
Nowadays, it’s not a secret anymore that many companies on wall street use various accounting methods to make their earnings look overly smooth and better than the business does in reality.
The net income of a company on the income statement plays an important role, as it primarily leads investors to either buy or sell a company’s stock. This can oftentimes be observed, for instance when the price of a stock adjusts shortly after the announcement of the recent earnings by a business.
Therefore, it is no surprise when the management of a company wants to utilize all the options that they have to meet the expectations of shareholders and investors due to the pressure they are faced with. However, overinflated earnings are a dangerous sign for long-term investors, who prefer to have stability and growth.
What matters at the end is the cash, which the company brings in after subtracting all accounting effects and capital expenditures. This figure is called free cash flow, which is much more truthful and essentially tells you how much you get to keep as an owner of that company.
There are many companies out there, which could, for example, have a low P/E ratio, (hence high earnings compared to its current stock price), while also having solid growth for the future, but when you take a closer look you realize that they are producing next to nothing or even negative free cash flow. An investment made on such a company could be much more dangerous than its P/E ratio initially indicates.
P/E Ratios Differ from Industry and Stock Type
The price of a stock is determined by its investors, who try to make a positive return by predicting the future outcome for that company. Therefore, the P/E ratio can be imagined as a number, which reflects the expectations by the market for the growth of that specific stock. Those expectations can be very different amongst the types of companies and the industry in which they operate.
For example, would you consider International Paper Co (IP), an American pulp and paper company to grow faster than Amazon Inc, a multinational technology company, which seems to expand its operations across the whole world?
The answer is no. And that’s also how the market views it. As of March 2020, International Paper (IP) has a P/E of about 10, compared to Amazon (AMZN) with a P/E of 85, that would conclude that Investors are willing to pay a higher price for Amazon’s earnings since they expect much more growth from the business in the future.
International Paper Co operates in the paper industry, which isn’t about to explode in the foreseeable future from its basic actions. On the other hand, Amazon has several other business segments operating within multiple fast-growing industries in addition to a huge customer base, while they are expanding internationally, and have the innovation and its trending hype on their side.
As a result, it is reasonable to compare companies and their P/Es with other similar businesses that operate within the same industry, or with the average P/E of all companies in that industry. As already mentioned, a P/E of 30 might seem completely ‘normal’ for a stock like Facebook or Alphabet whereas, the same P/E would be very questionable for a company like International Paper Co.
Conclusion
The price-to-earnings ratio is a relatively handy metric, which can be used to quickly take a glance at the valuation of a company and its earnings. However, it is certainly not the only valuation to rely on. Using other metrics like the D/E ratio, CAPE ratio, PEG ratio and the P/FCF ratio can help you further analyze a company from very different perspectives. Additionally, you should always find out the reasons why the P/E of a stock is in its current state and evaluate if the market is right or wrong with its valuation.
