Exercise caution when it’s PE time

ONE myth that seems to continually plague investing frameworks is the efficacy of the price/earnings, or “PE”, ratio in stock valuations.

“THE great enemy of the truth is very often not the lie — deliberate, contrived and dishonest — but the myth — persistent, persuasive and unrealistic.”

These words of wisdom from John F. Kennedy apply to many areas of our lives and surely to many aspects of investing.

One myth that seems to continually plague investing frameworks is the efficacy of the price/earnings, or “PE”, ratio in stock valuations. While ubiquitous in the process of many fund managers, it is eerily absent at Montgomery.

Any investor in the stockmarket has surely come across the PE ratio.

It is the ratio of a company’s stock price to its earnings per share.

It is a sensible first step in trying to provide some meaning to otherwise meaningless parameters in isolation.

Indeed, we estimate as much as 85 per cent of equity research reports are based on relative multiples and comparisons, so investors can be forgiven for being led down the road of conventional wisdom.

Ask an investor what comes to mind when a PE ratio of, say, six times is offered.

“Cheap” will likely be the first word that comes to mind.

On the other hand, test reactions to a PE ratio of, say, 25 times. “Expensive” will be the response, of course.

If only investing were so easy.

Most investors intuitively understand that a higher PE ratio can be justified if a company’s earnings-per-share is growing more rapidly. After all, if earnings per share are growing at 15 per cent per annum, then in five years, the earnings per share will have doubled.

In a sense, this is like saying the five-year PE ratio of the stock is half the level of the current PE ratio. Those who subscribe to such thinking often point to the PE ratio as their tool of choice.

This logic, however, may or may not be valid. To a man with a hammer every problem looks like a nail. The missing ingredient is the investment required to achieve the growth in earnings per share. If earnings per share can grow at 15 per cent per annum without the company having to make any material reinvestments into its business — a rare but highly desirable situation — then a higher PE ratio can absolutely be justified.

But what if the company needs to make significant reinvestments into its business, or acquisitions, to achieve such earnings growth? Imagine that, for every incremental dollar of earnings, the company had to spend, say, $20 in capital investments or acquisitions.

Should this company’s earnings per share be worth the same PE multiple as the company described above that does not have to spend anything to achieve its earnings growth? Absolutely not.

Actually, in the latter scenario the more the company invests to grow, the more shareholder value is destroyed and the lower its PE ratio should be. As an aside, the market frequently and perversely gets this back to front, sometimes presenting short selling opportunities.

Another myth associated with the PE ratio is that it is comparable between the stocks of different companies.

It is certainly more comparable than, say, a company’s stock price — which in isolation is an entirely meaningless number.

But there is a key problem with comparing the PE ratios of different company shares: it implicitly assumes the companies being compared are funded with similar proportions of debt and equity. This is often untrue in practice.

If the revenue line and/or the EBITDA of a company slumps, a shareholder who purchased the company’s shares on a PE ratio of, say, 10, with a large amount of debt, will suffer a much sharper fall in wealth than a shareholder who purchased on the same PE ratio, the shares of a company that had the same earnings but had less debt.

Two businesses, identical in every way except for how their assets are funded, will have very different PE multiples, especially if there is a hit to the revenue line.

Investors should proceed with caution when comparing PE ratios of different companies — particularly when they are in different industries.

The PE ratio can be a helpful first step in providing some meaning to otherwise meaningless isolated parameters.

Yet investors should not be hasty in drawing conclusions from PE ratios without further analysis, particularly with respect to the drivers of earnings growth within the business.

Finally, investors should remember that comparing PE ratios between companies is only valid in particular circumstances.

Roger Montgomery is the founder of Montgomery Investment Management.