How To Invest

Why you shouldn’t use the P/E ratio to value every stock

‘To a man with a hammer, everything looks like a nail.’ – Mark Twain

We cannot use a single valuation method (the hammer) to determine the worth of every stock (the nail). Companies in different industries have their own unique set of characteristics. Using the same ruler to measure the performances of all companies out there is akin to judging a fish’s ability to climb a tree — we end up thinking the fish has no potential.

Similarly, to avoid missing out on investing opportunities, we don’t want to use the P/E ratio to value every stock you come across. Here’s why.

The P/E ratio

The price-to-earnings (P/E) ratio is one of Wall Street’s most common valuation methods. We hear the term thrown around a lot on CNBC or Bloomberg where news anchors and financial experts use the ratio to quickly assess whether a stock is ‘cheap’ or ‘expensive’.

The P/E ratio compares a company’s share price relative to its earnings power. For example, if a company has a share price of $100 and generates an earnings per share of $5, that will give us a P/E ratio of 20. This essentially means that investors are willing to pay $20 for every dollar of the company’s earnings. The higher the P/E ratio, the more investors are willing to pay for every dollar of earnings.

But a high P/E multiple does not necessarily imply that a stock is overvalued. For example, if you bought a stock for $100 and the company doubles its earnings per share from $5 to $10, the P/E based on your cost price is reduced to 10. Because of the growth of the company’s earnings, it now seems like we got a great deal!

Likewise, a low P/E multiple does not signify a bargain. If the company’s earnings decline by 50% to $2.50, the P/E based on your cost price is now 40. Suddenly, we realize that we’ve got a dud we can’t wait to get rid of.

So essentially, whether the P/E multiple you paid for a stock is high or low depends on its future growth. As long as we don’t overpay for growth, we will all do well in the long run.

‘Price is what you pay, and value is what you get.’ – Warren Buffett

Another factor that causes investors to assign a high multiple to a stock is the certainty of the business. These are usually defensive stocks with high recurring earnings such as Coca-Cola.

The business of the world’s most popular soft drink has matured a long time ago. So even though its growth is limited, Coca-Cola still trades in the range of between 20 to 30 P/E due to its certainty. Even during the Global Financial Crisis, when Coca-Cola traded as low as 17 times earnings, consumers did not stop drinking Coca-Cola products. In fact, they drank even more, driving Coca-Cola’s revenue from US$28.9 billion in 2007 to US$31.9 billion in 2008.

The P/CF ratio

The P/E ratio is best applicable to companies that have consistent earnings. But if you applied it to growth companies with inconsistent earnings, you would have missed out on amazing stocks like Amazon.

Amazon’s historical P/E ratio is off the charts. The company has traded near to a P/E of 4,000 before and has an average P/E ratio of 267.7. There’s no way I’m paying $267.70 for every dollar of earnings, right?

Amazon P/E 2007-2020. Source: YCharts

The reason for Amazon’s stratospheric P/E is because the company’s net profit is depressed due to Amazon continually reinvesting its profits for future growth. Before 2016, Amazon only made an annual net profit of more than US$1 billion once.

But Amazon’s cash flow tells a different story – its operating cash flow grew at a compounded annual growth rate of 31.8% from US$1.4 billion in 2007 to US$38.5 billion in 2019.

Source: Amazon

It is common to see high-growth businesses like Amazon exhibiting choppy earnings due to the varying level of capital reinvestments that are made throughout the years. For a company that generates a consistent cash flow but low earnings, it’s more appropriate to use the price-to-cash-flow (P/CF) ratio to determine the intrinsic value of the company.

Amazon P/CF 2007-2020. Source: YCharts

From the price-to-cash-flow (P/CF) chart above, we can see that Amazon normally trades between 20 to 35 times operating cash flow and has an average historical P/CF ratio of 28.0. Anything below or above the historical average indicates that the company is undervalued and overvalued respectively.

The P/B ratio

When it comes to financial institutions, the price-to-book (P/B) ratio is a better way to value the company. Financial institutions such as banks, insurance companies, and brokerages are cyclical in nature; they are sensitive to the level of economic activity and interest rates.

The brokerage firm Charles Schwab has grown its total client assets consistently over the past 15 years. But since half of Schwab’s revenue comes from net interest income, the fluctuations in interest rates will cause its earnings to fluctuate despite the growth in total client assets.

For example, although total client assets increased from US$1.45 trillion in 2007 to US$1.57 trillion in 2010, the interest rate cut after the Global Financial Crisis caused Schwab’s earnings per share to shrink despite a larger asset base, decreasing from US$1.99 in 2007 to US$0.38 in 2010.

However, throughout the cycles, Charles Schwab has never failed to grow its book value per share.

Source: Charles Schwab

In such a situation, using the P/B ratio can smoothen the kinks of the economic cycle. When interest rates rise, the P/E ratio of the company might be lower due to higher earnings. Conversely, the lowering of interest rates may cause the P/E ratio to be much higher due to lower earnings. So, it’s very difficult to put a pulse on the intrinsic value of the company to know when it is undervalued or overvalued.

But with the P/B ratio, we can gauge a financial institution’s earnings power based on the amount of its assets under management.

Charles Schwab P/B ratio 2007-2020. Source: YCharts

From the P/B chart above, we can see that Schwab normally trades between 2 to 5 times book value and has an average historical P/B ratio of 3.7. Anything below or above the historical average indicates that the company is undervalued and overvalued respectively.

The fifth perspective

Hopefully, this article puts more tools (besides hammers) into your toolbox to value the different companies out there in the stock market. We can use the P/E ratio to value companies with consistent earnings, the P/CF ratio to value high-growth companies with consistent operating cash flow, and the P/B ratio to value financial institutions with stable growth in assets under management and book value.

It is important for us to use the right tools, but don’t be obsessed in getting the most precise intrinsic value of a stock; we are all making decisions with incomplete information. Different people with different experience levels and access to information will arrive at different values for a stock.

What’s more crucial is for us to understand the quality of a business, its growth drivers, and to be aware of the risks we are taking on. When you understand an investment well enough, you will know you are getting a good deal when the price of it drops below a certain point.

Kenny Quek

Kenny Quek is a research analyst at The Fifth Person. He graduated from Drexel University in Philadelphia, PA with a major in finance and previously managed a fund in the U.S. before returning to Singapore.

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