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 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.
“As a measure of undervaluation for me, P/E may not be terribly useful, as I may hope the company spends aggressively to exploit their nascent franchise advantages in markets and the spending may reduce current income. [For example] Berkshire has done a tremendous amount of investment that destroys current income so you can't really use P/E” Thomas Russo
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 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…
There Is No Single Metric
First things first, there is no single formula that leads to investment success.
"I don’t think price-earnings ratios, determine things. I don’t think price-book ratios, price-sales ratios — I don’t think any — there’s no single metric I can give you, or that anybody else can give you, in my view, that will tell you this is a great time to buy stocks or not to buy stocks or anything of the sort. It just isn’t that easy." Warren Buffett
“I wouldn’t look for a single metric like relative P/Es to determine what, or how to invest money.” Warren Buffett
‘Value Investing’ Is Not Buying Low P/E Stocks
Many investors confuse the term ‘Value Investing’ with buying stocks on low multiples. It’s not. Value Investing is buying a company for less than it’s intrinsic value. In layman’s terms it means you’re going to get back more than you outlaid. You’ll get an attractive return on your money and if your assumptions are out, you’ve still got a decent chance of doing okay because you allowed yourself a margin of safety.
“Whether appropriate or not, the term ‘value investing’ is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth, and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics - a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield - are in no way inconsistent with a "value" purchase." Warren Buffett
“The ‘value/growth dichotomy’ is false - at least, to a true value investor, whose aim is not to buy stocks which are ‘cheap’ on accounting measures (P/E, price to book, etc.) and to avoid those which are expensive on the same basis, but rather to look for investments trading at low prices relative to the investor’s estimate of their intrinsic value.” Marathon Asset Management
High P/E Stocks Can Be Value Stocks
Of course, everyone would like to buy high quality companies on low P/E ratios. Unfortunately that’s often not possible. History suggests that high quality companies that compound capital at high rates of return could have been purchased at very high multiples and still delivered attractive returns. Stocks that look ‘optically expensive’ on traditional ‘value metrics’ can still be great investments, provided they deliver earnings growth, even in the event of future P/E compression.
A recent Investment Insight note by Lindsell Train’s Nick Train, looked at the history of McDonald’s:
“.. by the start of 1990 McDonald’s was now trading at over $8 – an 8-bagger since 1980. Historic earnings were $0.48, for a P/E of 18x. I imagine in early 1990 there was prolonged discussion in institutional investment meetings about what the right P/E should be for McDonald’s and whether 18x wasn’t a bit rich – especially for a stock that had already done so well. Of course – with hindsight – we can now be sure that any debate about the valuation of McDonald’s in 1990 was more or less irrelevant. It could have been valued on over 50x and even at that rating it would still have performed in line with the S&P 500 through to today. (The S&P rose 7.5x between 1990 and 2018 and McDonald’s 22x – nearly 3x as much. Therefore McDonald’s could have been nearly 3x more expensive in 1990 and still performed in line.) And any quibbling about the valuation that actually encouraged a sale of the stock was downright ruinous.
Yet we all know that the credibility of the investment professional who argues that such and such stock is overvalued on 18x is often higher than that of the investor who counters along the following lines. “I don’t know what the right rating or price is for McDonald’s today, I just think the business has a lot of growth ahead of it and that we should hang on and just ignore the valuation, except in extremis.”
Terry Smith, in Fundsmith Equity Fund’s 2013 letter, looked back on the performance of Colgate and Coke;
“We examined the relative performance of Colgate-Palmolive and Coca-Cola over a 30 year time period from 1979-2009. Why 30 years? Because we thought it was long enough to simulate an investment lifetime in which individuals save for their retirement after which they seek to live on the income from their investment. Why 1979-2009? We wanted a recent period and in 1979 it so happens that Coca-Cola was on exactly the same Price Earnings Ratio (“PE”) as the market – 10x and Colgate was a little cheaper on 7x. The question we posed is what PE could you have paid for those shares in 1979 and still performed in line with the market, which we took as the S&P 500 Index, over the next 30 years?
We found the answer rather surprising - it was 36x in the case of Coke and 34x in the case of Colgate when the market was on 10x. Another way of looking at it is that you could therefore have paid a PE of 3.6x the market PE for Coke and 4.9x the market PE for Colgate in 1979 and still matched the market performance over the next 30 years. The reason is the differential rate of compound growth in the share prices (to a large extent driven by growth in the earnings) of those companies over the 30 years. They compounded at about 5% p.a. faster than the market. You may be surprised that this differential can have such a profound effect upon the outcome. It’s the magic of compounding.
.. Coke & Colgate’s total returns grew at about 5% p.a. faster than the market over the period 1979-2009, this 5% differential multiplied their share prices four times more than the market over that period. Of course, the next 30 years may be different to the 1979-2009 period.
It is also fair to point out that quality stocks may indeed not be too expensive relative to the rest of the market but that both will prove to be expensive, particularly when interest rates rise. But even so, I suggest you consider how you might have reacted if someone had suggested that you invest in Coke or Colgate at say twice the market PE in 1979. In rejecting that idea you would have missed the chance to make nearly twice as much money as an investment in the market indices over that period which included some periods of very high interest rates. Of course, capturing this opportunity would have required you to have the fortitude to sit on your hands during those periods of high interest rates and poor performance. As at 31st December 2013 they were trading at PE’s slightly above the market – our portfolio was on a PE of 20.6x versus 17.4x for the S&P 500, which doesn’t sound quite so expensive when you look at their historical performance and quality.”
And finally Polen Capital’s September 2018 Insights titled ‘Wonderful Companies at Fair Prices’ looked at the relationship between strong growth and P/E ratings and the implications of future P/E de-ratings …
“We spend far more of our time understanding the earnings potential of a business rather than trying to determine its fair value. Strong earnings growth is not only indicative to us of a potentially great business, but of a business that may be able to protect investor capital through a range of financial and economic circumstances. The charts in Figure 1 illustrate this point.
The chart on the left shows the effect of four different scenarios of earnings growth, P/E multiple compression and the resulting annual rate of return on a $100 investment in the same company. The first scenario (top line) is the most straightforward: assuming a company’s EPS grows 15% per year for five years (with no dividend payments) and its valuation doesn’t change, the investor’s annual rate of return over the five-year period will be 15%. In the second and third scenarios, the company’s EPS growth remains at 15% per year but the P/E of the company’s stock decreases by 10% and 20%, respectively, over the five-year period. In these two scenarios, though the valuation works against you, the investor still realizes annualized returns of 12.6% and 10%, respectively because the EPS growth remained strong. In the last scenario (bottom line), the company’s EPS growth is once again 15% but the valuation compression is more significant with a P/E ratio reduction of a full 50% over the five-year period, yielding a 0% annualized return for the investor. While not ideal, it is still worth pointing out the obvious: the investor didn’t lose money. Thus, even in the scenario where one arguably invested in an overvalued business, the underlying EPS growth provided a buffer and helped to prevent capital loss.
The chart on the right in Figure 1 presents the effects on the resulting annual rate of return for a $100 investment in the same company in a scenario where both the EPS growth of the business decelerates and the P/E ratio compresses. In this dynamic, over a five-year period the earnings growth could slow from 15% to 10% and the P/E multiple could contract by nearly 40% - yet the worst outcome would be flat returns. Put another way, EPS growth and valuation projections would need to be overestimated by more than 33% for an investor to lose money over the five-year time horizon.
This is how we approach valuation. It’s not overly complex nor is it meant to be. If, after thorough analysis, we have high confidence in a company’s ability to deliver attractive investment returns over a sustained period, then it becomes a business worth considering for our portfolios. projection Importantly, this return may very well assume that the stock’s P/E multiple compresses over our time horizon.”
The Polen article provided the examples of Visa and Alphabet where despite P/E contractions, the stocks delivered outstanding long run returns. In the case of Alphabet, the stock delivered 25% annualised returns, significantly outperforming the market, despite a near 60% PE compression.
“Perhaps the most notable thing about the Alphabet example is that the 25% annualized return was achieved despite the stock’s valuation compressing significantly. Alphabet’s forward P/E ratio was over 70x at one point in 2004 but then steadily declined to as low as 12.5x by 2012 (an 80% decline in valuation) before steadily recovering. Even with that recovery, Alphabet’s P/E declined by nearly 60% over the entire period and yet that significant P/E multiple compression did not prevent the investor from achieving outstanding long-term returns.”
The reason Alphabet could sustain such a significant PE compression was because earnings growth dwarfed the impact of the PE de-rating on the stock price. Finding companies with high earnings growth provides protection against a PE de-rating.
“If you have an asset that’s growing earnings at 20%, your money is doubling roughly every 3 ¼ years. If you could have a five year time horizon and let’s say your money goes up 3 fold and you buy at a reasonable price, there is literally no way you lose money. If its cashflows grow 3 fold and you bought it at a reasonable price there is no scenario where you lose money. If the multiple gets cut in half or by 75% you still win assuming you bought it reasonably. I am not assuming you bought it at 500X or something like that. Having underlying growth of the cashflows solves so many problems so I always look for things that actually are generating some form of growth. I don’t know what the multiple will be in 2 years, but I know I underwrote it well.” Jason Karp
A recent excellent post by Morgan Housel summarised why over time a company’s earnings growth has a larger impact on a stock’s value than the multiple. It’s about compounded earnings.
“Valuation changes have a majority impact on your overall returns early on because company earnings are likely the same or marginally higher than when you made the investment. But as earnings compound over time, changes in any given year’s valuation multiples have less impact on the returns earned since you began investing.” Morgan Housel
Source: Collaborative Blog, Morgan Housel
Over time the impact of purchase multiples fade while earnings growth and ROE determine long term returns.
“While valuation multiples matter a lot in the short-term – they drive stock performance tremendously in years one through three – in years three and beyond, the impact of a change in multiples, unless extreme, fades when it comes to long-term capital compounding.” Yen Liow
Buffett and Munger have long recognised the benefit of buying wonderful companies at fair prices, as opposed to fair companies at wonderful prices.
“Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price.” Warren Buffett
Over the years, they’ve shown a reluctance to part with high quality companies despite high multiples. They’ve even recognised the benefits of such companies buying back their own shares at high multiples, implying they believe intrinsic values are higher than those prices.
“The last bit of Coke Warren bought in 1990 was bought at 25X trailing earnings. So it wasn’t cheap by traditional metrics, but on many fronts they considered it a no-brainer.” Mohnish Pabrai
"In GEICO, we paid 20 times earnings and a fairly sized multiple of book value." Warren Buffett
"If you’re right about the companies, you can hold them at pretty high values." Charlie Munger
"We really have a great reluctance to sell businesses where we like both the business and the people. So I don’t think I’d count on seeing many sales. But if you ever attend a meeting here, and there are [holdings at] 60 or 70 times earnings, keep an eye on me.... You can really hold them at extraordinary levels if you’ve got [wonderful businesses]." Warren Buffett
"Looking back, when we’ve bought wonderful businesses that turned out to continue to be wonderful, we could’ve paid significantly more money, and they still would have been great business decisions. But you never know 100 percent for sure." Warren Buffett
“When we own stock in a wonderful business, we like the idea of repurchases, even at prices that may give you nose bleeds. It generally turns out to be a pretty good policy.” Warren Buffett
“The really great companies that buy [back stock] at high price-earnings, that can be wise.” Charlie Munger
Buffett makes the point above “you never know 100 percent for sure”. And therein lies the difficulty. The problem is, the future is never knowable. The key is to get comfortable such businesses have longevity and will continue to compound into the future. Ordinarily such businesses display a track record of performance, high and sustainable returns on equity, and excellent management. As few businesses can sustain high earnings growth over a period of ten to fifteen years most don’t deserve premium multiples. And when companies on high PE multiples stumble due to high earnings growth expectations that didn’t transpire, the results can be brutal; a double de-rating as earnings and the P/E ratio get marked lower. Paying high multiples for speculative stocks with limited track records is gambling not investing. It’s very, very dangerous.
“Most investors usually confer the highest price-earnings ratios on exotic-sounding businesses that hold out the promise of feverish change. That prospect lets investors fantasize about future profitability rather than face today's business realities. For such investor-dreamers, any blind date is preferable to one with the girl next door, no matter how desirable she may be. Experience, however, indicates that the best business returns are usually achieved by companies that are doing something quite similar today to what they were doing five or ten years ago.” Warren Buffett
Focussing On Low P/E’s Can Lead You Into Value Traps
Screening for low P/E stocks, unsurprisingly, can lead you into low quality businesses. It’s one of the reasons that many of the Investment Masters focus on business quality first and valuation second.
“Many of our value competitors start the process of identifying likely investments by starting with price. Looking at a screen. We don’t believe in those screens. Cheap looking stocks will end up on screens. They will be either the lousiest competitors in an industry or operating in industries which are overly competitive. What makes us want to investigate a stock idea? - it’s not that it looks cheap - but if there seems to be something unique or superior about it. It may not optically look cheap.” Charles De Vaulx
"I’ve found that when valuation is the overriding driver of interest, I’m prone to get involved in challenging businesses or complicated ideas and liable to confuse a statistically cheap price with a margin of safety." Allan Mecham
"When you find a “cheap” stock, you can easily convince yourself that the long-term prospects of the company are great. That is why I try not to look at valuation at the beginning of the process. Cheap is not cheap when you hope for an increase of the P/E ratio in the short-run even though the long-term economics may be poor." Francois Rochon
“We try to avoid value traps by not making valuation the first, second, or third thing we look at. We never base our thesis on valuation alone. .. When you are analyzing your portfolio and opportunity costs, if the only thing your thesis rests on is ‘it's cheap,’ then it is time to move on.” Dan Davidowitz
“Too many investors focus on price first and business quality later, if at all. While every asset has a price, there are many we wouldn’t touch at any price, or with a ten-foot pole. Price is not value.” Chris Bloomstran
"I used to spend a lot of time screening the market according to typical value criteria such as price to book or P/E, but I now do this a lot less often. I find that these types of screen naturally direct you to cheap stocks, whereas what I am looking for are value stocks. The two things are not the same. I much prefer to make the first cut according to whether a company has a wide moat as the time is unlikely to be wasted." Robert Vinall
“We want to avoid value traps like the plague. That’s when you get down to the execution of value investing. Value investing works really well when it is well executed. But you can’t be superficial. You can’t just say it’s got a low PE, or a high dividend yield. Those are dangerous things.” CT Fitzpatrick
"Starting out I was a Graham and Dodd investor, focused on low price/ earnings ratios, good balance sheets and high dividend yields. The problem with that is you can get caught in too many value traps. I concluded I was better off focusing primarily on two key variables in weighing investment attractiveness: company valuation and business quality." David Herro
Summary
It should be clear that simply picking a stock based on the P/E level is a not sound investment strategy. Whilst some of the early indicators may suggest that a stock is a steal because of favourable ratios, it has been proven time and time again that it will more than likely end up being a value trap.
I’ll leave you with some final thoughts on this topic from some very wise people…
“In the evaluation of any business, we believe investors are best served by taking the time to fully understand the enterprise before giving appropriate consideration to its valuation.” Dan Davidowitz
“If you plan to hold a share for the long term, the rate of return on capital it generates and can reinvest at is far more important than the rating you buy or sell at.” Terry Smith
“We think, that the parameters that circumscribe “cheap” and “dear” in investors' minds are much too narrow. Investors are “anchored” to the top and bottom ends of a valuation range in a way that is not economically rational and is, therefore, inefficient. It can be hugely rewarding to buy a value-creating, strategically-advantaged company on 20.0x earnings and hugely damaging to your wealth to buy a supposedly “cheap” stock, in a value-destroying company on 10.0x.” Nick Train
“The idea that value investing means buying a company with a low p/e makes no sense. A company with a 20% incremental return on equity and is trading at 20X earnings, but can retain that return on equity for a long period of time because it has competitive advantages, is a way better value than a company trading at 10X earnings that has an 8% return on incremental capital. You can graph it out and over time those lines cross.” Chris Davis
“The funny thing with the investing business is that sometimes you can buy something at 20 times earnings and it can be cheap depending on the moat and the runway.” Mohnish Pabrai
“On my time horizon, the calibre of a company is much more important than its value. You can be wrong about value in the short term, but still have a great investment over time. My worst errors have come from overestimating a company's business model, not overestimating the worth of a fine company.” Nick Train
Further Reading:
‘How growth became value and value didn’t,’ Terry Smith, Fundsmith.