Valuation Multiples: Convenient but Dangerous

Investor Education

There are all sorts of price multiples, ratios and metrics that investors have come to rely on as shortcuts in determining whether a stock is undervalued or overvalued. Many private investors and even large investment houses rely on these shortcuts in order to make investment decisions.

However, such a strategy is naive- these metrics can provide a quick and simple guide to valuation but they come with substantial flaws that investors need to be aware of.

Let’s start with the one most commonly used by far: the price-to-earnings ratio, often referred to as the P/E ratio. This is a ratio of the price per share divided by the earnings per share (EPS)- it tells us how many dollars we need to pay to buy $1 of company earnings.

For example, a stock trading at $100 per share with an EPS of $5 would have a P/E ratio of 20x ($100 divided by $5). Similarly, a stock trading at $20 per share with an EPS of $1 would have a P/E ratio of 20x. In each case, investors are paying $20 for each $1 of earnings. A P/E ratio of 50x would imply an investor was paying $50 dollars for each $1 of earnings and so on.

The Problem with P/E Ratios

All else being equal, it’s better to buy stocks with low P/E ratios because we get more earnings per dollar we spend. Due to its simplicity, the P/E multiple has become the most often quoted tool in the press and online. But it can be very misleading and dangerous to rely on it in leu of doing the necessary and hard work of understanding the business- because P/E ratios have some significant shortcomings:

1) A P/E ratio uses only one year of earnings. Is one year of earnings enough to establish the value of a company? Businesses are long term assets- they (should) exist for decades. To value them based on an arbitrary 12-month window does not give us the whole picture:

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.

2) P/E Ratios do not account for different company structures. P/E ratios make companies with conservative balance sheets look more expensive, and they make risky companies that carry a lot of debt look cheaper. This can clearly lead investors astray. Let’s take a real-life example:

Apple trades on a P/E ratio of 18x this year’s earnings. But Apple has $240bn of net cash on its balance sheet. If we were to buy the whole of Apple, that cash would be ours, so we could can take that off the amount we’d have to pay to buy the company. Apple’s market cap is $950bn. We can therefore subtract the $240bn of cash on the balance sheet, so the ‘real’ market cap is $710bn. Using that to create a PE ratio shows that Apple is actually trading on only 13x earnings, not the 18x we see when looking at face value.

On the flip side, a company like AT&T has net debt of around $170bn, so it will appear at face value to be cheaper than Apple. In reality, not only is it riskier as it carries so much debt, it’s also more expensive:

3) The ‘earnings’ in the price-to-earnings ratio are an accounting concept- not a real cash value. We should always exercise caution when valuing a business using anything other than genuine cashflows. This is because earnings as a number is relatively easy for a management team to manipulate in the short term; buybacks, provisions, capitalizing costs, write downs, inventory management etc can be used to push the earnings number both up and down. Any manipulation of the earnings number will affect the P/E ratio.

We Can Do Better

An improvement on using a P/E ratio would be an EV/ EBITDA ratio (Enterprise value/ Earnings Before Interest Tax Depreciation Amortization). This has the benefit of accounting for different capital structures by using EV rather than market cap, and using EBITDA as an ‘earnings’ metric, which is much closer to actual cash income than the earnings used in the P/E ratio. But such a tool still suffers with the time frame issue- using short-term returns to value a long-term asset.

For our approach, we spend a lot of time trying to work out the intrinsic value of a business. To be able to do this most accurately, we utilize a technique called a Discounted Cash Flow (DCF). This will be covered in more detail in a future post. But put simply, to value a company on a DCF basis one must work out what the cash generation will be from now until long into the future. You then take those future cash flows, and discount each of them back to today (a dollar today is worth more to us than a dollar in 10 years’ time) to generate a far more economically grounded valuation for a company.

In closing, it is important to remember that valuation is both an art and a science, and always be careful when looking at or relying on simplistic and misleading accounting ratios.

Disclosures: This website is for informational purposes only and does not constitute an offer to provide advisory or other services by Globescan in any jurisdiction in which such offer would be unlawful under the securities laws of such jurisdiction. The information contained on this website should not be construed as financial or investment advice on any subject matter and statements contained herein are the opinions of Globescan and are not to be construed as guarantees, warranties or predictions of future events, portfolio allocations, portfolio results, investment returns, or other outcomes. Viewers of this website should not assume that all recommendations will be profitable or that future investment and/or portfolio performance will be profitable or favorable. Globescan expressly disclaims all liability in respect to actions taken based on any or all of the information on this website.

There are links to third-party websites on the internet contained in this web-site. We provide these links because we believe these websites contain information that might be useful, interesting and or helpful to your professional activities. Globescan has no affiliation or agreement with any linked website. The fact that we provide links to these websites does not mean that we endorse the owner or operator of the respective website or any products or services offered through these sites. We cannot and do not review or endorse or approve the information in these websites, nor does Globescan warrant that a linked site will be free of computer viruses or other harmful code that can impact your computer or other web-access device. The linked sites are not under the control of Globescan, and we are not responsible for the contents of any linked site or any link contained in a linked site. By using this web site to search for or link to another site, you agree and understand that such use is at your own risk.

Valuation Multiples: Convenient but Dangerous

Valuation Multiples: Convenient but Dangerous

Share this post

Related Posts