When it comes to work, everyone likes a short-cut to success; in investing it’s no different. And the one short-cut investors use a lot of the time is the ‘Price to Earnings’ or ‘P/E’ ratio. Using this, you make an estimate of what the company’s earnings per share will be in the forthcoming year, and then divide that into the current share price. Hey presto, you’ve got a ratio you can compare against other companies and a tool for picking stocks. Great, huh?
It’s a nice way to think but in reality its not that simple.
Needless to say relying on the P/E ratio can be problematic. There are a few issues with it – here’s are some of the more obvious ones …
While the ‘Price’ component in the P/E ratio is pretty foolproof (assuming you can get volume there), relying on the ‘Earnings’ can cause some problems. Sometimes the earnings of a company don’t reflect the cash available to management and shareholders; lots of capex could be required or revenue is accrued rather than received in cash, etc.
Alternatively, a company’s earnings could be depressed by short term investments which will yield high returns in coming years, thus understating the current earnings power of the business. Complicating matters further, the P/E ratio doesn’t take into account the capital structure; is a lot of debt required to produce the earnings? These are all considerations that need to be made.
But it’s also the level of the P/E ratio that can send the wrong signal.
When most people think of ‘value investing’, there’s a natural tendency for them to think of stocks on low P/E ratios. I certainly started out my investment advisory career in that camp. I was always looking out for ‘cheap’ stocks; low multiple companies that could benefit from multiple expansion and an improved earnings outlook. I deemed high P/E stocks as the antithesis of value investing – far too dangerous.
Over time, my appreciation for what makes a value investment has dramatically changed. While investing in high P/E stocks can be dangerous, I now place far less emphasis on low P/E ratios, and more on the quality of the business and it’s ability to continue to grow. I’ve learnt from Buffett and Munger and many of the other Investment Masters about the true power of compounding and its ability to diminish the importance of the P/E ratio over time. I’ve also witnessed the capital destruction that sometimes results from chasing low P/E stocks.
This essay draws on some of those insights…