Is the P/E ratio really as useless as I think?
Has the market’s enthusiasm eroded all the safety out of buying stocks? I think so. In fact, for a few weeks now I have been saying that there are very few (read 1 or 2) quality stocks that are cheap. Equity markets are now selling off as investors get nervous again and start thinking about risk. It does appear to me that the rally has not been justified by the economic fundamentals, but more about the US economy in a minut
If you don’t already know, I have no use for P/E ratios. Let me explain why.
Suppose three companies each have $10 of equity per share, each returns 20 percent on that equity and each is trading on a P/E of 10, which equates to $20. The only difference is that the first company is paying out 100 percent of its earnings as a dividend, the second is paying out 50 percent and the third is paying no dividends. If you were to assume that you could buy and sell the shares at the same P/E of ten, the first company would return 10 percent per annum over any number of years, the second would return 15 percent and third will return 20 percent per annum. The third is clearly the cheapest and yet all three had the same P/E of 10. P/E’s can’t tell you very much about valu
There are however times when P/E’s are at such extremes that they provide support to my preferred analysis of the spread between price and value. This is one of those occasions and so, without recognising the validity of P/E’s, I will provide those of you who use P/E’s with the fix that you need.
By definition, if the US economy is recovering, then we recently experienced the last month of the US recession. It would be worthwhile examining the P/E ratio for the S&P/500 Index on the previous occasions that represented the last month of a recession.
Let me start by noting that currently, the trailing P/E is 27. This seems extreme and out of nine recessions since 1954, it is the highest trailing P/E at the last month of a recession, with the exception of November 2001. The other eight observations ranged from a trailing P/E of 8.3 in July 1980 to 17.2 in March 1991. Now some of the years in which the P/E’s were very low were also years of very high inflation, but even if those years are removed today’s trailing P/E is comparatively high.
Many of you will correctly point out that it makes no sense to use trailing P/E’s if we are coming out of a recession because the trailing ‘E’ is unusually low. In such situations, analysts focus on forward P/E’s. (Of course you know my view; if P/E’s are nonsense, then forward P/E’s, sector average P/E’s and the like are simply nonsense squared).
Nevertheless, on one-year forward estimates, the P/E ratio is at 16 times. This is the highest it has been since 2003. Even at the peak of October 2007, the forward P/E was about 14 and the highest it has ever been is 15.4 times.
But while it seems that multiples have, in six months, surged from historic lows to all-time highs, and while conventional wisdom would suggest that P/E’s are at levels normally reserved for the late stages of a bull market, there is a counter argument; at market peaks, such as October 2007, analysts are unusually bullish about the future, while after a recession analysts will be overly cautious about their forecasts. The result is low relative forward P/E’s at peaks and apparently high P/E’s coming out of a recession.
Confused? I am. That’s why I don’t use P/E’s, because they try to predict what the predictors will predict.
What do I really think? I think the stock market has got ahead of itself and the high quality businesses that I look at are now trading above their current valuations and are trading at their valuations two years out. Based on trailing and forward P/E’s (did I tell you I can’t stand P/E’s?) the US market has behaved as if it is in the late stages of a recovery and yet there is still debate about whether the recession is over. US inflation at this stage does not appear to be a threat. Indeed Target and Walmart have started their sales early… that sounds like deflation to me. In the US, rent, restaurant prices, airfares and the prices for personal care products, education, household appliances and tools, hardware and outdoor equipment, confectionary and soft drinks are all plunging. For the week of October 23rd, mortgage applications fell 12.3%! And this was on top of a 13.7%(!) slide the week before. On top of the fact that the Federal Reserve’s Beige Book has indicated that consumer spending remains weak. as does residential construction, architectural billings and commercial construction activity, this suggests that the market has cast its shadow too far forwar
Imagine what the US economy would look like without a $2 trillion injection!
By Roger Montgomery, 29 October 2009
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
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Tyler
:
Buffet states in his owners manual that Book value is useless, “In all cases, what is clear is that book value is meaningless as an indicator of intrinsic value”
rogermontgomeryinsights
:
Hi Malcolm
You make some good general observations about inflation and cashflow however even in combination they don’t amount to a process for navigating between good and bad businesses nor expensive or cheap opportunities.You’re right about limits to the accuracy of reported profits and book values. Suppose for example, a company is earning $20 million on $100 million of equity which is equivalent to a 20% ROE and that entity is sold into another company shell prior to being listed by its owners. It is transferred at the float price of $200 million. The books will now show $100 of goodwill on the balance sheet and the ROE will be 10%. The business however is the same business as before and the despite the change in the ROE which merely reflects the willingness of investors to pay more, there is no change to the entities economic performance.
By either avoiding companies with large on-balance sheet intangibles and focusing on those with real economic goodwill or simply adjusting the equity, you will end up with a reasonably good estimate of intrinsic value. It won’t be as precise as the AGAAP figures but as Buffett said it is better to be approximately right than exactly wrong. I make a bunch of adjustments when investing my own capital but the differences it produces are usually not significant for the high quality businesses I seek. For example one of the adjustments is to subtract from reported profits an estimate of the likely ongoing maintenance capital expenditure for a business to remain in its competitive position. This is a very large number for Qantas and other companies that have a high proportion of assets to profits but its a smaller difference for service businesses or those that use the LIFO inventory method.
If you make sensible adjustments to earnings and equity you get a very good estimate for intrinsic value using ROE and Equity which the PE cannot pick up. With PE’s you are tracking price – far more dangerous than tracking the economic performance of the underlying business.
Over the last ten years however if you had just taken the reported numbers and applied my valuation model, you would have avoided the litany of headline-grabbing corporate collapses like the ABC’s and Babcocks and done really well buying The Reject Shops, JB Hi-Fi’s, OAMPS, Fleetwood, Woolworths et al. Even with the reported numbers, I can show you that you will have done better than the market by using ROE and Equity than you will with PE’s.
For more on Inflation, ROE’s, cash flow, LIFO and Book Value read The Essay’s of Warren Buffett by Lawrence Cunningham.
I appreciate your comments and wish you every success in your own investing.
Good investing
Malcolm
:
Yes, there are problems with PE ratio and also with ROE
• Both measure accounting profit which is susceptible to manipulation.
• Equity / Book value of equity can be misleading esp. in case of businesses having sizeable intangibles like IT companies, etc. Book Value doesn’t capture value of businesses and hence ROE is not the right metric.
• In times of inflation, costs such as depreciation, inventory, etc. tend to be understated because the replacement costs of goods and services generally rises with inflation. Thus PE ratios tend to be lower in such times as the market awards a lower multiple to companies in such times as it sees earnings as artificially distorted upwards.
Best thing to refer to is a combination of metrics which use operational cashflow or free cashflow. However it should be remembered that free cashflow can remain negative for growing businesses which demand heavy investments in their growth stage. Cashflow from operations (CFO) can be negative for working capital intensive businesses like Construction businesses, Mining etc
Conclusion: No single ratio will serve as the right “yardstick” but what matters is the stage of the business, management and your objective as an equity investor.
Phillip
:
Interesting article Roger. I remember the first book I read on the stockmarket, the writer mentioned that he would never buy a stock with a P/E over 20. I guess he would miss out on some good stocks! By the way, I was watching CNBC US recently when they mentioned that Amazon was on a P/E over 50. http://finance.yahoo.com/q/ks?s=AMZN
I enjoy your blog, many thanks for your efforts in providing these blog entries, it’s much appreciated.
James Zhang
:
Roger,
Reading the last part of your post. My question will then be: should I take out a large portion of my share investment out of the market and put it aside for the market to dive? Or, should I switch to the good ones like JBH WOR, etc?
rogermontgomeryinsights
:
Hi Andrew,
Unfortunately, having only recently left the businesses I founded, listed on the stock exchange and sold, I am not yet in a position to provide you with specific stock advice. I noticed you registered interest in my book. Now that I have your email address, I will be sure to let you know when I am able to assist.
Kindest regards,
Roger
Andrew
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I agree with this analysis, prices have overshot their true value. What I am a little more cautious about is that while deflation may be true of the US economy now, I cannot see how that can continue once demand picks up. Printing money like there is no tomorrow is sure to ramp up inflation at some point and, as with everything financial, the economy will turn on a penny. One cannot predict when it will turn. I appreciate that running a deficit does not necessarily mean inflation will follow – there is a complex nexus between deficits and supply and demand.
The problem for the US is an appetite for government ‘intervention’ and fiddling around with market mechanisms like executive salaries. This makes me nervous because it hinders the usual ‘supply’ logic of the market and is bound to raise inflation in the long term.