Is Price to Earnings useful?

Price to Earnings is a financial ratio used in company valuation. It relates how much investors must pay to own the company, with the earnings the company delivers. It’s therefore often called the Earnings Multiple.

It may be calculated alternatively on a per share basis, or considering the whole company, yielding in both cases the same number. In the first method, it’s computed as the Stock Price divided by the Earnings per Share. In the second, the Market Capitalization divided by total Net Profit.

It’s an approximate measure of how many years it would take to recoup the investment made (assuming earnings where to keep at similar levels and the interest rate is near zero). In principle, the lower the ratio, the faster the expected payback, the better for the investor.

Another way of looking at it is how much dollars an investor must pay initially to be entitled to get one dollar of earnings of the company from then onwards (until she eventually sells the shares).

When P/E is calculated using the earnings of the last four quarters, it’s called trailing P/E (TTM P/E, for twelve trailing months P/E), whereas if using the projected earnings of the coming four quarters, a future (or forward) P/E, for example based on Earnings Per Share (EPS) guidance.

Price to Earnings isn’t only used to estimate the true valuation of a company, but also of the stock market in general. It varies in time, but a historical average could be around 16.

Price to Earnings is also used as a filter in screeners to search for possible undervalued companies.

The inverse of Price to Earnings (profits divided by the price) is called Earnings Yield.

• It’s an easy measure to understand.
• It’s easy to calculate (only two inputs).
• A rough measure of company valuation.
• Can be used to compare different companies, or the same company at different moments in time.
• Can be used to assess the general stock market valuation.
• Can be used as filter criteria in stock screeners.

Price to Earnings ratio omits some very important information regarding company valuation. Let’s take a closer look:

It can’t be measured when the company report losses

Price to Earnings has no discernible meaning when the company incurs in a loss. The payback concept becomes irrelevant until profits are made.

Many companies report losses from time to time, so Price to Earnings as a sole measure could be invalid for valuating many stocks at a given time.

P/E as a single and year specific measure

Deciding a company valuation on a single ratio could be very unwise. What if the metric doesn’t consider all the important factors? P/E does have some important shortcomings and we’ll discuss some of them in the following sections.

What about being a year specific measure? Ok then, consider the following Warren Buffett’s argument. Imagine you want to buy a farm. Would you base the valuation of it on how much it rained in the last twelve months? Or on the rain forecast of the coming twelve months? Surely not, being wise you would assess the farm worth on normalized earnings, say normal productivity considering the average weather, not of any particular year. Doing otherwise, you could end with a very distorted valuation, over or under valuated depending on the bias of that year.

That’s why you should use more than one measure for company valuation, an also with normalized inputs, say representative earnings averages (whereas past or expected, both have pros and cons). Earnings power should be a normalized measure, represent how much under normal circumstances a company is able to deliver.

Growth and Price to Earnings

Another important element that’s omitted in Price to Earnings is growth. Once again, imagine two company have the same P/E, so theoretically the estimated payback in years is about the same. But not necessarily! Suppose company A growths a lot faster than company B. Revenues and earnings are growing two digits in company A, while B is vegetative (or worse, it could even be shrinking). All other factors being the same, company A will have a shorter payback than B, and so deserving a higher current Price to Earnings.

How higher? The difference in growth rate could be a first approximation. That’s why PEG (Price to Earnings Growth) was created, to adjust for the growth shortcoming. PEG is calculated as the Price to Earnings ratio, divided by the yearly growth rate of the company. The lower, the faster the payback, the better. PEG of less than one could in principle mean undervaluation (but that isn’t always the case).

Peter Lynch, arguably the top exponent of Growth Investing, warns against investing in companies with very high P/E (say, higher than 60), because that could mean that a huge amount of expected growth is already included in the price, making it very risky if said growth isn’t then realized. For example, if the company is expected to grow at 20% yearly, and it “only” grows 10%, shares are likely to suffer.

Benjamin Graham, the ideological father of Value Investing, also advocated against purchasing firms with huge Price to Earnings. In his view, the future is something to be cautious about, some degree of uncertainty and risks must be considered. Using an overstated expected growth rate could be the way for justifying an overvaluation (and therefore a bad purchase).

Think about glamorous high growth companies. Ok, they’re desirable (maybe even sexy), right. But research shows that it’s very challenging to outgrow your competitors in revenues (and earnings growth) every year for very long periods of time. And that’s one of the big disadvantages of PEG. Financially, when you divide the earnings amount by the expected growth rate (the “terminal value”) you’re calculating a perpetuity. It would be unwise to use a growth rate much higher than the general rate of the whole economy. Otherwise, if a company growths forever at 10% yearly, while the whole economy growths say at 4%, that implies that eventually the firm will be more valuable than the whole economy, which is straight absurd!

So, if you use a very high rate, the perpetuity calculation of PEG will be distorted, but if you use the same terminal economy growth rate for all companies, then PEG would be no better than just P/E. If you truly are into the discounted cash flow model, project the earnings (or more precisely, cash flow) for the coming periods when the growth rate is higher than average, and then use the economy rate for the terminal value estimation.

A whole (sensible) strategy of investing is around buying growing firms (Growth Investing, proponents of the de GARP concept, Growth At a Reasonable Price). But beware, bear in mind that expected growth should be achievable and not just euphoric daydreaming. When everybody believes the firm is going to grow a lot, the stock price could already be overvalued.

Financial position and Price to Earnings

Now suppose two companies have the same P/E, so at first guess the relative valuation is similar. Ok but, say, suppose one of the companies is swimming in cash and liquid financial assets, while the other is swimming in financial debt. Surely the company in better financial position could be worth more than the other, therefore deserving a higher P/E.

And why is that? Think about it in a couple of ways. The company in better financial shape, could use the cash to reinvest in the business, possible fueling the growth of the company. Or it could buy its own shares (a.k.a. repurchases or buybacks), giving back some cash to investors, driving demand of the stocks up and pushing the stock price. Or, it could buy another profitable business right away, therefore increasing EPS, driving P/E down (which should rebound by the way, when stock price rises to reflect that). Or it could also decide to pay dividends to shareholders.

Another way of understanding why financial position needs to be considered in P/E, is the following example: suppose company A has a low PE, and is also swimming in cash, and has no financial debt. Hypothetically, a major investor could ask for a loan at a bank on her behalf, use the funds to purchase the company, then use the cash of the firm to pay a dividend (to herself as owner), and finally use the received funds to pay back the bank loan. In the end, the investor would have bought the company for free, or at least, with very few investments of her own money.

On the other hand, said company B swimming in debt deserves a lower PE. Why? Because it’ll probably spend a few years repaying it before being able to think about rewarding some cash to its own investors.

If P/E weren’t to be adjusted for net financial position (cash and equivalents minus financial debt) it could be grossly over or under valuated. That’s why Adjusted Price Earnings was created, where Cash and equivalents are deducted from the paid price, while debt is added. Adjusted Price Earnings is an improved and more sophisticated version of plain P/E.

Could you adjust both growth and financial position? Like, calculating an Adjusted Price Earnings Growth? Yes, that could be an improvement, but the specific single year metric warning is still applied. Could you normalize it? Yes, possibly another improvement, but the terminal rate cautionary warning still applies. Also, more data input would be needed, loosing simplicity, and becoming harder to explain.

Depreciation may not be representative of capital needs

Depreciation is an accounting expense that apportions the buying cost of a fixed asset (say, an industrial machine) over a long (usually more than a year) period of time (say, the timeframe in which the assets is exploited). It’s an accounting calculus, for the firm doesn’t need to pay for the amortization charge.

But with time, the fixed asset probably gets old and obsolete, and needs to be replaced to keep up with competitors. So, over the period in which the asset was used, the company should have theoretically earned at least enough money to buy a new one. Buying a new one is called capital expenditures and is a discretional decision of capital allocation by management.

The higher the investments that need to be made to replace fixed assets, the lower the available cash to reward investors. That’s why some investors prefer low capital needs when selecting business.

There isn’t guarantee the depreciation and capital expenditures are similar, not even in the long run. The company could have very old assets and in deep need of replacing them. Or it could need very few fixed assets, for example if it deals mostly on knowledge or other assets to operate.

Sometimes it isn’t easy altogether to check for consistency, think for instance in a gold mining company. Is it buying enough mineral reserves to compensate for the fields it is depleting? Does it need to pay more or less than it used to in capital expenditures to sustain the mineral reserve base?

Whenever depreciation and capital needs aren’t comparable on a reasonable basis, cash available to reward investors could be much more (or less) than what P/E seems to indicate.

If you compare P/E of companies of various industries, you’ll see that on average they aren’t necessarily similar. Different capital needs may be among of the causes for it.

Price to Earnings may be procyclical

Let us get to it with another example. Suppose a company has a very volatile business, as when commodity prices seriously affect its revenues (and earnings). Think of oil, gold, or soybeans for example.

Now, suppose oil prices are way high, and the company is making a killing on extracting it. Earnings of that year then consequently go up. If stock price remains, then P/E goes down. Investors could be tempted to buy the stock, as the P/E seems to indicate a quick payback. If investors buy the stock on account of the low P/E, the stock price goes up, and P/E recovers to former levels. New investors end up paying more for the shares than what they were trading for before.

Now, suppose oil price returns to a more normal (and lower) range. Company profits consequently trim to more modest levels. If stock price remains constant, then P/E would go up. So, investors are now tempted to sell the shares, to drive Price to Earnings back to normal levels. The sellers may lose now, as they might have to sale the stock for less than what they bought them for.

Thus, P/E may act as a tempting force for investors to buy the shares when results are extraordinarily high, and dump them in recessions, behaving procyclical.

The same example can be thought the other way round, when results are abnormally low (say, in a recession, and stock prices are undervalued for being based on lower-than-normal earnings of that year). That’s why Contrarian investment has advocates (as Baron Rothschild claimed, buying when there’s blood on the street).

If you read the normalization idea commented before, stock price shouldn’t have moved so much. Again, it isn’t sensible to drive so much company market value up or down on transitory effects. The oil company of the example should have had a more stable valuation, because on average it delivers normal level returns.

So, bear this in mind when tempted to buy low Price to Earning stocks when profits are not sustainable. Or that maybe a higher TTM P/E could mean that the market expects profits to improve in the future.

Price to Earnings may not reflect business risks

Risk also is among the causes why P/E isn’t the same among companies. Imagine again two companies with the same Price to Earnings ratio. One is very stable, while the other is very volatile in terms of profits. Suppose on average they deliver the same earnings, and everything else is the same.

Would you be willing to pay more for the stable company (the one that yields the same results and cash flow every year) than the other that’s a wild guess? If so, how much more?

What about not only business risk but financial risk? Say, one company is heavily indebted and the other not. If business turns sour for both, the one debt free will tend to escape more unscathed than the other. Is that worth a higher Price to Earnings? Ok, probably. How much? It depends on your own risk aversion, and on the estimation of the likelihood and consequences of a possible downturn.

P/E may incite short term behavior due to accounting principles

Under US GAAP, a firm must recognize research and development as expenses, even when those expenses could prove successful in increasing future cash flows by improving business prospects. Therefore, under P/E ratio, a firm could improve its metric by taking short term measures, like cutting back R&D. Short term profits will increase, but in the long run investors will probably be worse.

Company could be fatally flawed

Now think of a company heavily involved in a dying business model, with no real chance to fight its new competitors. In such scenario, it’ll probably be wiser to try to evaluate the business on a liquidating value (what owners could salvage after selling all the assets and paying all the creditors) than using Price to Earnings (maybe business won’t be likely to continue in the future, or earnings could be already shrinking, or even generating loses already). P/E will drop relevance, however low it may seem.

Bear in mind the other way round is possible too: a scenario where doom is mostly perceived (difficulties aren’t terminal or barely crippling the business) and a low Price to Earnings could be truly a sing of undervaluation (that’s what some Contrarians investors typically search for).

For another case that could justify a very low Price to Earnings, think about a company that’s suspected of cooking its accounting books. Ok, if the books are real, then it could be undervalued. But what if not? If the books are truly cooked, then the earnings you’re seeing aren’t real, and Price to Earnings without a true measure is meaningless. Can you reasonable estimate how much the books are distorted? That would be more than a challenge to do for a retail investor.

Of course, there’re red flags indicators you could use to try to spot the rotten apples, but that’s off topic for this article.

Price to Earnings disadvantages summary

• It’s meaningless when the company reports losses.
• Price to Earnings is a single and usually year specific measure (not normalized).
• Growth isn’t considered; the investor is left with trying to guess how much higher P/E ratio is deserved for a higher growth business (PEG tries to fix this).
• Financial position isn’t considered (Adjusted P/E tries to fix this).
• Capital needs may not be truly reflected in the ratio.
• It may be procyclical, inciting wrong decision timing.
• It may not reflect the true business risk, both operational and/or financial.
• It may reward short term behavior at the cost of sacrificing the future (e.g. cutting otherwise successful R&D expenses, or advertising budget).
• Company may (or may not) be fatally flawed, however low it seems.

If Price to Earnings were a true measure of value, we would probably see a convergence in the ratio for different companies. Given that it doesn’t converge, other important omitted factors are being considered by investors, many of which were mentioned in this article.

While Price to Earnings may be used as a rough valuation metric, keep in mind its many shortcomings. It could be useful for screening purposes for investing ideas, or if you’re already familiar with the company for quite some time (you should invest in what you know, just as Warren Buffett states), or as a general market assessment. Use it to learn about the company, for it’s unwise to relay on it as a sole metric (or any other single metric for the matter).