P/E Multiples: helpful or misleading?
If you ask most investment firms or analysts how to value a company, almost all of them will respond with some version of ‘you estimate next year’s earnings as accurately as possible and then you put a multiple on it.’ However, such a strategy is not just naïve and removed from real business valuation, it’s downright misleading. Sure, simple multiples like PEs (price earnings) can provide a quick and simple guide to valuation, but they also come with substantial flaws that investors need to be aware of.
Let’s start with the most commonly used multiple: the price-to-earnings ratio, often referred to as the P/E ratio. This is a ratio of the price per share divided by the earnings per share (EPS) and it tells us how many dollars we need to pay to buy $1 of company earnings.
For example, a stock trading at $100 per share with an EPS of $5 would have a P/E ratio of 20x ($100 divided by $5). Similarly, a stock trading at $20 per share with an EPS of $1 would have a P/E ratio of 20x. In each case, investors are paying $20 for each $1 of earnings. A P/E ratio of 50x would imply an investor was paying $50 dollars for each $1 of earnings and so on.
The problem with P/E ratios
All else being equal, it’s better to buy stocks with low P/E ratios because we get more earnings per dollar we spend. But all else is not equal and it can be very misleading and dangerous to rely on a P/E ratio in lieu of doing the necessary hard work of understanding the business:
1. A P/E ratio uses only one year of earnings.
Is one year of earnings enough to establish the value of a company? Businesses are long term assets. They (should) exist for decades. To value them based on an arbitrary 12-month window does not give us a complete picture:
2. P/E ratios will undervalue growth.
Taking a snapshot of short-term earnings does not give credit for future earnings growth. For example, a stock such as Facebook trading on 28x next year’s earnings may look expensive vs the S&P 500 on 17x, but it is in fact a lot cheaper when you consider it’s growing earnings at 30%+ every year. To buy Facebook, you’re paying a 60% valuation premium, but we get more than 100% extra in earnings growth. In just two years of compounding earnings at 30%, that 28x P/E ratio would become 12x, assuming the price stayed the same. What initially looked expensive, now looks cheap.
The flipside is true of declining businesses. Looking only at last year’s earnings won’t account for the fact that earnings might be falling every year. So, we can easily end up overvaluing a slowing or declining business.
3. P/E ratios are countercyclical.
When we are at the top of a cycle, and earnings are unsustainably high, P/E ratios will make businesses look cheap. When we are at the bottom of the cycle, and earnings are non-existent, P/E ratios will make businesses look expensive. Thus, P/E ratios are sending the exact opposite signal that we want – they lead investors to buy high and sell low.
4. P/E Ratios do not account for different company structures.
P/E ratios make companies with conservative balance sheets look more expensive, and they make risky companies that carry a lot of debt look cheaper. This can clearly lead investors astray. Let’s take a real-life example:
For much of 2020 Apple traded on a P/E ratio of 18x. But Apple had $240 billion of net cash on its balance sheet. If we were to have bought the whole of Apple that cash would be ours, so we can take that off the amount we’d have to pay to buy the company. Apple’s market cap was $950 billion at the time, so we can therefore subtract the $240 billion of cash giving us a ‘real’ market cap of $710 billion. Using that to create a P/E ratio shows that Apple was actually trading on only 13x earnings, not the 18x we saw when looking at face value.
On the flip side, a company like AT&T had net debt of around $170 billion, so it appeared at face value to be cheaper than Apple. In reality, not only was it riskier as it carried so much debt, it was also more expensive:
5. Earnings are not reliable.
The final flaw with PE is that the ‘earnings’ in the price-to-earnings ratio are an accounting concept and do not necessarily reflect the economics of the business. You should always exercise caution when valuing a business using anything other than genuine cashflows.
This is because earnings as a number is relatively easy for a management team to manipulate in the short term; buybacks, provisions, capitalising costs, write downs, inventory management etc. can be used to push the earnings number both up and down. Any manipulation of the earnings number will affect the P/E ratio.