In 1963, a young football coach by the name of John Madden attended a coaching clinic at the University of Nevada. The coach speaking that day was the Green Bay Packer’s legendary coach, Vince Lombardi. Madden, at the age of 27, believed he knew everything about football. Lombardi, with a quarter century of coaching experience under his belt, described one play, the power sweep for eight hours. Yes. You read that correctly. One play. Eight hours. He broke down the nuances of the play – how to execute the power sweep, read the defense’s adjustments, and make corresponding offensive adjustments. No detail was too small to include. It was a true masterclass. Today, the masterclass is on the Price to Earnings Ratio.
The Price to Earnings Ratio (P/E Ratio) is one of the most expedient metrics to judge a company. In its most pure sense, the P/E ratio is the price of a stock divided by its earnings per share (EPS). What makes P/E ratios popular is their inverse: the earnings yield. Flipping P/E to E/P provides an extremely rough approximation for the expected return of a company’s stock. If the stock of Company A trades at $100 and earns $8 per share, its P/E is 12.5 and its earnings yield is 8/100 or 8%. Company A is expected to approximately return 8% per year if bought at current prices. This is where a lot of people stop reading and just go out and hunt for low P/E stocks. That is a massive mistake. If you want to become a better investor, keep reading and learn the nuances of the P/E ratio.
Non-Recurring Items (NRI):
The first distinction with P/E ratios comes in the form of non-recurring items. Non-recurring items are a one-time expense that are not expected to continue. There are many examples of NRIs, think things like litigation accruals or restructuring charges. NRIs are an expense on the income statement, and thus lower earnings. By lowering the denominator of the P/E, NRIs can make the P/E higher than it would be under standard business conditions. If Company A trades at $100 per share and earns $8 per share but has a $2 per share non-recurring item, its P/E goes from 12.5 to 16.6. Now the earnings yield has dropped from 8% to 6%.
In addition, companies frequently manipulated NRIs due to GAAP accounting standards. Many subpar companies tend to have one-time restructuring costs seemingly every year. Companies doing this can mean many things. What’s important for an investor to see is the frequency and amount of NRIs to see if a company expense routine business costs as part of their normal business operations. Accounting like that might make the P/E look more attractive than the economic reality of the business.
Forward P/E Ratio:
When you see a stock’s current P/E ratio, what you are most likely seeing is the stock’s historical or trailing twelve-month (TTM) P/E ratio. Although this is a useful data point, company’s earnings change as time goes on. The forward P/E is an estimate of what the company’s P/E ratio will be in the future. If Company A trades at $100 per share and earns $8 a share, it has a 12.5 P/E. However, next year it is estimated Company A will earn $12 per share and now it has a forward P/E of 8.3. Conventional wisdom dictates that if you purchase Company A at current levels and then it earns 50% more next year and its P/E ratio declines, then you will have a great investment. Why? Because if Company A is fairly valued at a 12.5 P/E and earns $12 per share next year, the company will have multiple expansion back to a 12.5 P/E based on those $12 per share in earnings and now the fair value for the stock is also 50% higher at $150 per share.
Despite the attractiveness of using a forward P/E, it also has a major flaw – forward P/E ratios are based on estimates of future earnings. When you see a forward P/E, that is no better than an amalgamation of a bunch of analysts collectively modeling public information on an Excel spreadsheet to guess what they think the company will earn. In other words, the forward P/E is more like a pro forma for real estate cash flows. The TTM tells you factually what the earnings were, the forward P/E gives optimistic assumptions about the future.
Price/Earnings to Growth (PEG) Ratio:
The PEG ratio is another common metric closely related to forward P/E. The PEG ratio is the P/E ratio divided by Earnings Growth per Share. Investors oftentimes take a sloppy view an assume if the PEG ratio is below 1.0 the stock is undervalued because the P/E ratio is less than the earnings growth, and if the PEG ratio is above 1.0 the stock is overvalued due to a higher P/E ratio than earnings growth.
This is a sloppy tool for two reasons. First, assigning a static number to a stock to decide undervalued or overvalued is crass. Even the best investors in the world assign a possible range of intrinsic values for a business based on a multiplicity of factors ranging from industry knowledge to policy factors to market sentiment. Therefore, assigning a simple yes/no metric to indicate if a business is overvalued or undervalued is lazy. Secondly, the PEG ratio’s denominator has the same problem as the forward P/E ratio – it is based on an outsider’s estimate of what the earnings growth will be. Most analysts mean well, but modeling on Excel 5-7% earnings growth based on a company saying 6 months ago on a conference call they expect mid-single digits growth does not reflect real business prospects. In other words, things change. That company could have secured a large contract for a new customer or lost one customer that accounts for 20% of net sales.
Industry by Industry:
P/E ratios vary by industry. One of the most common traps for new investors are cyclical companies like auto manufacturers. Auto manufacturers typically trade at a P/E from – to 10. What is a P/E of –? An absence of a P/E, indicated by a – means that company is net income negative in the previous 4 quarters. Auto manufacturers are a classic example of companies that do not behave according to conventional wisdom of P/E ratios. When an auto company does not have a P/E, the stock is cheap and beaten down. Sentiment is extremely negative. As earnings improve, the stock improves. The stock trades higher, boosted by cyclically high earnings. At this point, a company’s P/E usually sits in the 5-10 range. Novice retail investors spot a 5 P/E and think they are locking in a 20% earnings yield. Then as the credit cycle contracts, the P/E starts to slip higher and higher until the company contracts and starts losing money again. The stock sells off and the P/E reverts to a –.
The automotive manufacturing industry is one example of many industries in the market. Each industry has its own homeostasis P/E. If all the companies in an industry are doing reasonably well, profitable, and have no near-term headwinds, similar companies generally trade within a similar P/E of each other. For example, at the time of this writing, JP Morgan Chase (NYSE:JPM), Wells Fargo (NYSE:WFC), Bank of America (NYSE:BAC), Capital One Financial (NYSE:COF), and Citigroup (NYSE:C) all trade within a P/E range of 9-13. These are all large, stable banks that offer the same services. It would be a mistake to pick one out and assume because its P/E is 9 that it is better run than a competitor with a P/E of 12.
One further example to bolster my case. The four major airlines: Delta Airlines (NYSE:DAL), United Airlines (NASDAQ:UAL), American Airlines (NASDAQ:AAL), and Southwest Airlines (NYSE:LUV) trade between 7-13 times earnings. Southwest is the outlier with its P/E at 13. The other 3 trade in the 7 P/E range. Does this mean you would be better off owning DAL, UAL, or AAL instead of LUV? Southwest is the only one of the four major carriers that has never had a bankruptcy, has the most growth prospects in terms of international expansion, and has temporary headwinds due to the Boeing 737 Max since the 737 is the only plane Southwest uses. Overall, the companies trade in a relatively tight range.
The point of this is this does not mean airlines and auto manufacturers are bad or good stocks. The point is each industry carries a range of P/E multiples. Buying solely based on a low P/E could result in owning a lot of busted companies. Speaking of busted companies…
Value traps are stocks that have a low P/E ratio among several other metrics that make a company look cheap. Let’s consult Company A again to learn about value traps. Company A trades at $100 per share and in the past, it previously earned $8 per share. Company A has a 12.5 P/E. However, Company A missed earnings and only earned $6 per share. Now Company A trades at a P/E of 16.6. But the market reacts and sells the stock down from $100 to $70. Now the stock has a P/E of 11.6. If the earnings are temporarily impaired or the company missed from a legitimate one-time expense, this could be an opportunity. Now let’s say that Company A, a brick and mortar retail stock, is at $70 when a huge online e-commerce giant announces it will to enter the space. Company A stock drops 40% on the news. Company A stock now trades at $42 with its same $6 of earnings for a 7 P/E. The online giant wins because their prices are better and Company A misses on the $6 of earnings – they only earned $3.50. On this news, Company A’s stock slides 50%. Now their stock trades at $21 with $3.50 of earnings for a 6 P/E. Is Company A at a 6 P/E earning $3.50 a share and losing market share as attractive as the same company that once earned $8 per share and had a 12.5 P/E?
Company A’s story while fictitious is a classic value trap story. Value trap businesses screen cheaply, but they are busted business models. Many new investors experience value traps firsthand as they find a stock with a 3 P/E and buy it without digging deeper. There can be some money made in the value traps if the stock stumbles upwards on short-term unexpected news, but long-term holding value traps is a great way to lose money.
Market Multiples and Multiple Expansion:
Think about high-quality companies like Coca-Cola (NYSE:KO) or Procter & Gamble (NYSE:PG). These two companies have wide moats, universal products, and no real threats. These are companies that are extremely stable and steady. Their results aren’t exciting to new investors today. But to investors going back 50 years, the results were consistent and grew steadily. Sure, there might have some headwinds – millennials are slowly turning away from soda and house brands are taking some share from PG, but these businesses are two things: large and consistent. Even if they miss on their earnings or free cash flow, they are still going to have billions in FCF every year.
The market loves consistency and rewards businesses for being consistent with a premium P/E multiple. There is a reason why it is perfectly reasonably for KO to receive a 30-40 P/E multiple while National Beverage (NASDAQ:FIZZ) – La Croix and other brands, has a 15-20 P/E multiple. At the time of this writing, KO has a 28 P/E while FIZZ has a 17 P/E. This is because out of the companies, KO has a longer history of larger and better results. FIZZ might be a better investment moving into the future, but its P/E lower than KO’s does not reflect valuation, but market psychology that KO has produced larger results for longer.
In the same theme, companies sometimes expand their multiples. One example that everyone should know is Costco Wholesale (NASDAQ:COST). In 2005, the stock traded around $43 with a 19.9 P/E. COST’s market cap was around $20 billion. Today, the company trades at a 36 P/E, right around $300 per share and a $135 billion market cap. In the past 15 years Costco has expanded, kept their costs low, remained consistent and fanatic about passing their savings on to members, and grown its annual FCF from $781 million to over $3 billion. COST transcended from a regional retailer in the United States with a strong concept to an exceptional brand that is known worldwide and synonymous with value for members. The market rewarded COST with multiple expansion. That is why COST gets a 36 P/E while a competitor that is nowhere in the same league, BJs Wholesale Club (NYSE:BJ) commands a 13 P/E.
Businesses can have inflection points that make their P/E ratios appear wonky – making a stock look extremely undervalued or overvalued.
Let’s introduce a new company called Company B. Company B is a microcap stock with an 80 P/E, an earnings yield of 1.25%. Yikes! But what if I told you Company B went from previously losing money and is now net income positive. An 80 P/E is just a temporary occurrence as the company just inflected to profitability. That is a business that could easily be on the path to being a multi-bagger as Company B grows and more money falls to their bottom line. This 80 P/E is not telling of the situation and the stock could be quite undervalued.
Similarly, as previously mentioned in the industry section, boom or bust earnings can give a company an unrealistic P/E. A manufacturing company at peak profitability in the credit cycle could carry a 3 P/E and be a terrible investment to own over the next few years, while the same company a few years later with an 80 P/E could provide great value as the environment changes and the company flips back towards larger, sustainable earnings.
In many instances, manipulation of a company’s financials impacts their P/E ratio. There are many ways to manipulate financials in GAAP accounting, and I could not begin to list them all. However, here are a couple to illustrate my point.
Aggressive Revenue Recognition: Remember how Wall Street likes smooth, predictable earnings? Most companies don’t have smooth revenue. It becomes a problem when companies become overly aggressive with moving revenue forward. Think about a company that charges $120 for a 12-month subscription service. In most instances, the company would realize $10/month from deferred revenue on their liabilities on their balance sheet and move that $10 to revenue on their income statement. Let’s say the company was weak on subscribers for the accounting period and they decided to recognize $60 instead of $10. If all their costs remain the same, a disproportionate amount of this $60 could fall to the bottom line, boosting earnings and thus making the P/E look more attractive than the company’s actual situation.
Delaying Expenses: Sometimes if a business has a large expense, they push it forward out of the current accounting period. A business can take a large expense and instead of legitimately recognizing it as an expense, push it to the balance sheet classifying it as an investment that needs to be capitalized. This manipulates earnings by making net income appear higher than it is, thus bolstering the P/E ratio.
There are many more ways a company can manipulate its financial statements. There are several high-quality books and publications that detail the ways in which a company can manipulate their financial statements. I highly recommend you check out these books if you want to become a better investor and gain a deeper understanding of financial statements.
Share buybacks are a politically taboo topic. There is a lot of information present on share buybacks, so I will skip over the often-repeated facts of buybacks. Here’s a deal – share buybacks massively boost net income per share but do not have any effect on net income. It’s simple (let’s leave out nuanced accounting for preferred dividends, etc.). If Company C trades for $5, has one million shares outstanding, and had a net income of $200,000, Company C earned $0.20 per share. Company C has a 25 P/E. If Company C bought back 10% of their outstanding shares and repeated their exact results, they would have earned $0.22 a share. Now Company C trades at a 22 P/E.
Regardless of political opinion, share buybacks reduce shares outstanding and thus increase earnings per share and lower the P/E ratio. In modern finance, share buybacks are often not value accretive. This is because companies will buy back stock at the peak of the credit cycle when their company is flush with cash and needs a place to invest excess cash. This means companies often buy back expensive stock and artificially drag their P/E ratio back down to earth in a sustainable range.
One sign of intelligent capital allocation within a company is a company that sets limits for buying back shares. This varies company by company. It could be if the company is trading below its book value or if the company is trading at a small multiple of the company’s FCF. If you find a company that outlines criteria for buying back their stock, chances are you have found a company with excellent capital allocation skills.
Cyclicality/Market Extremes (Bull/Bear):
There are two ways to think about cyclicality as it affects the P/E ratio. The first is through the perception of industry by industry. This was already covered – think automotive stocks and the point in the credit cycle.
The second way to think about cyclicality is overall in the market. Presently we are a decade-plus strong in a bull market. This means that stock prices have generally outpaced earnings growth. Companies and industries that usually carry a 15 P/E are now carrying a 25-30 P/E. This is tough to account for as from first glance the companies could look overvalued. But in a market where everything trades at an inflated multiple, this cyclicality needs to be accounted for. If the $100 stock earned $8 and had a 12.5 P/E, but now a few years later earns $10 per share and is given a 25 P/E the stock is now trading for $250. The stock certainly looks expensive since its P/E has doubled, but if all its peers are overvalued, seeing a higher P/E does not mean the stock is inherently expensive, but rather it is still trading around its peers due to the market’s cyclicality and the point in the credit cycle. The same holds true in a deep bear market where quality companies could trade at a single-digit P/E.
Economists Robert Shiller and John Y. Campbell introduced the Cyclically Adjusted Price-to-Earnings Ratio (CAPE), most commonly called the Shiller P/E. In a nutshell, the Shiller P/E is the price of a stock divided by ten years of earnings adjusted for inflation. The Shiller P/E is thought of as a much better indication of the return a company can offer as it has ten years of earnings and should incorporate a couple market cycles in it.
In a traditional market, there is even more layer as one must think about if they are seeing two bull and one bear market or if they are seeing two bull and one bear market reflected in the Shiller P/E. Presently a Shiller P/E only reflects a long, drawn-out bull market. Like all other P/E layers, this is only one tool further understand a company’s valuation. I highly recommend reading Shiller’s Irrational Exuberance if you are interested in learning more about the Shiller P/E, investor behavior, and to gain a deep, nuanced understanding of bubbles.
P/E ratios are a useful tool when looking for potential investment opportunities. Too many investors simply learn the definition, think low P/E ratios are good, and immediately go out and hunt for low P/E stocks. P/E ratios are much more complicated and intricate than they appear. They are the outward appearance of what goes on inside a company. Whether a company is manipulating earnings, at an inflection point, or artificially attractive because it is a value trap, all this information is reflected in one quick, simple data point – the P/T ratio. Taking the intricacies of the P/E ratio, understanding, synthesizing, and forming your own conclusion about a stock’s P/E ratio will only make you a better investor.
Buy Irrational Exuberance: https://www.amazon.com/Irrational-Exuberance-Revised-Expanded-Third-ebook/dp/B00P6ZJ6HC/ref=dp_kinw_strp_1