Stop (over)using the PE Ratio

The ambiguities of the most popular stock valuation metric

To my view, the P/E ratio is like that old friend who seems reliable but often gives bad advice.

It's everywhere, easy to understand, and can be helpful - but if you're not careful, it might only cause distraction.

In today’s episode, we’re going to dive into why the P/E ratio isn't always the best metric to use for equity investments and why you may be better off just avoiding it.

Let's uncover its common pitfalls, so you can make smarter investment decisions without getting tripped up by this often overrated KPI.

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The Foundation of Value Investing: Earnings Yield

For decades, traditional value investing was all about buying 1 Dollar for less than 1 Dollar.

The search of discounted assets translated into finding companies yielding solid profits relative to their purchase price. The formula is simple:

Earnings Yield % = Net Profits ÷ Market Capitalization (same as EPS ÷ Share Price)

Companies with the highest earnings yields were, surprise surprise, the ones with the lowest Price to Earnings Ratios.

Vice-versa, high PEs would immediately warn of overvaluation, as stock prices were seen as too high compared to the earnings delivered.

Broadly speaking, valuation - of which the P/E ratio is one of the pivotal proxy - was a mandatory starting point for any investment decisions.

But nowadays, in an era of instant access to corporate information, the story ain't that simple. It is much, much more complicated than that…

Investors cannot just rely on low PE ratios in order to find great opportunities. I would say it's even the opposite. Let’s see why.

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Understanding Business Life-Cycle

According to another traditional definition of value investing, stocks are broken down to either ‘Growth’ or ‘Value’. To my view though, it's more appropriate to classify them as “optimized” or “unoptimized” for earnings.

In the classic business life-cycle scheme, earnings optimization is only reached in the maturity phase.

If we assume that P/E should be used taking into account normalized earnings, we can conclude that it’s wrong to use the P/E across all other phases.

Indeed, if we use P/E in the startup or acceleration phases, (considering profits of the past 12 months, or the next 12) stocks will only look overvalued because the denominator will still be compressed by CAPEX investments, Marketing and R&D expenses that are still vital to fuel the growth engine of the company. It’s like asking a kid to give a political speech. Just too early to pretend that!

If we use P/E in the decline phase, we expose ourselves to the risk of value traps.

Low PEs may be anticipate how Mr. Market has altready spotted business risks, driving price down before earnings follow next.

This simple idea must be applied whenever a company runs multiple businesses under one ticker symbol.

From this perspective, Tech stocks should deserve a separate analysis. When do they stop growing? Probably never. By definition, they almost never reach maturity. Think of Amazon: it has been trading at very high PEs for decades. Based on PE, it has always looked overvalued, and that's why many old-school investors missed out on it.

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Maturity: the P/E Trap Map

Okay, now that we have excluded both growing and declining businesses, what about mature ones?

Let's view it case by case:

• High PE (>25). Expert investors should ask themselves: are we in front of an overvalued stock or are there enough qualitative elements that justify a premium valuation? Why is there high demand? Is quality a reason for the stock price?

• Fair PE (12-18 area). Now the provocative question might be: what’s the point of carrying specific risk if I can buy the whole stock market at the same valuation? In this case, valuation can't be a decision making driver.

• Low PE (single digit to 12). Here the big question mark comes. Why is the market keeping the stock down? Can it be a deal or are we witnessing a value trap, where investors get appealed by low valuation to buy suffering businesses? Is Mr. Market already pricing in probable future bad news?

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P/E: too many fallacies

I'm actually surprised by how many finfluencers still mention P/E to trigger investing discussions.

Personally, it shows too many limitations for me to base any investment decisions exclusively on it:

• It does not take into account business life-cycle. We are business investors and we must understand that we are buying companies at different life stages.

• It does not consider debt. Companies with low PE but low Return on Invested Capital and negative excessive return (meaning ROIC < WACC) should be avoided.

• It is a static, little forward looking metric. Let’s take the 1-year forward PE: that’s still not enough forward looking for somebody who wants to be a patient long-term investor. We should fast forward earnings power to at least 3 years from now in order to become more patient than the average fund manager and win the time arbitrage of the stock market.

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So what to do instead? My Strategy

My approach to valuation is everything but consulting a few financial KPIs. It embraces both a few qualitative and quantitative steps:

• Understanding where the company stands in terms of business life cycle, overall and evaluating the individual business segments;

• Analyzing the Income Statement to study the impact of CAPEX, Marketing, R&D and SG&A costs on current profitability, together with Gross Margin and Products Price Elasticity;

• Projecting a 5-year Earnings Power simulation: I project scenario business plans to understand how much net profits could the company unleash in the future;

• Analyzing the Balance Sheet to weight the impact of Debt renovations to future earnings, and other aspects;

• Study the Net Income to Free Cash Flow reconciliation to discover additional levers of earnings potential (Stock-Based compensation, Amortizations, other non-monetary costs)

• Making up my mind around strong catalysts that might generate higher demand for a certain stock. For instance: dividend growth, shares buybacks, a strong MOAT, and so on.

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Thank you again for your valuable time.

Happy Investing,

Francesco - Business Invest