Valuation Multiples: Convenient but Dangerous
P/E ratios will undervalue growth: taking a snapshot of short-term earnings does not give credit for future earnings growth. For example, a stock like Facebook trading on 28x next year’s earnings may look expensive vs the S&P 500 on 17x, but it is in fact a lot cheaper when you consider it’s growing earnings at 30%+ every year. To buy Facebook, we’re paying a 60% valuation premium, but we get more than 100% extra in earnings growth. In just two years of compounding earnings at 30%, that 28x P/E ratio would become 12x, assuming the price stayed the same. What looked expensive, now looks cheap.
The flipside is true of declining businesses- looking only at last year’s earnings won’t account for the fact that earnings might be falling every year. So, we can easily end up overvaluing a slowing or declining business.
P/E ratios are countercyclical. When we are at the top of a cycle, and earnings are unsustainably high, P/E ratios will make businesses look cheap. When we are at the bottom of the cycle, and earnings are non-existent, P/E ratios will make businesses look expensive. Thus, P/E ratios are sending the exact opposite signal that we want- to buy high and sell low.
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