A fantastic guest article from Tim Sunderland, founder of Mitto Markets.
It’s about time someone said it. The famed P/E ratio cornerstone is possibly the most useless valuation metric, ever.
So there, I said it.
Right, glad I got that off my chest!
Everyday, we all gather round and exchange opinions with our hard-earned cash.
If we break down what trading is in its most simplistic terms, it’s just placing bets on our well-formed (and not so well-formed) opinions.
For me to sell something, I need to find an ill-informed sucker who’s prepared to bid for it.
*If I ever find that scum bag who sold me those oil exploration shares in 2011… Why I oughta, grrrrr (code for, do absolutely nothing and move on with my life)*
Now, before I go into a full character assassination of the P/E ratio, I think it wise to first understand what it is and why so many investors use it as their chapter and verse for any investment thesis.
Why do they use valuations like this?
P/E Ratio is simply the share price divided by the company’s reported earnings (per share).
Do this calculation, and you’ll end up with a number which you can compare to other companies.
The lower that number, the better the value.
The higher the number, the more you’re paying in terms of relative value.
“Expectation is the key word; a forecast builds a perception and perception is greater than reality.”
By now, we’ve all seen an episode of Dragon’s Den – and more importantly when the prematurely confident entrepreneur boldly claims they're seeking £100K for 10% equity stake in their sustainable, vegan and socially responsible cookie company (Deborah Meaden leans forward).
“So ya’ve valued yhaself at £1m pooonds, what’s ya earnings then?” shouts the angry Scottish man.
“Well, errrm, well we’ve sold £100 worth of beautifully packaged, sustainably sourced, vegan cookies Year-to-Date” responds the, now timid, entrepreneur. “After costs, we’ve earned £10”.
*visible scoff from the angry Scottish man. Deborah Meaden re-assumes her base-line seating position.
In Layman’s Terms, we’ve just witnessed a £1m price tag on £10 of earnings.
£1m/£10 = a P/E Ratio of 100,000. Even by Tesla’s standards, that’s punchy.
Angry Scottish man and Deborah Meaden have heard enough.
‘I’m out!’ they both declare.
Stupid company, daft valuation, idiot time wasting entrepreneur.
Angry, suspiciously tanned for December, Scottish man is still visibly shaking with annoyance.
And that’s your basic P/E ratio in a nutshell, why look anywhere else.
The cookie company is clearly a dud. Right...?
But then enters the seasoned market player.
The debonair one (other than James Caan)...
Mr Peter ‘Reggae Reggae, invest on the cord of a badly strung guitar’ Jones
‘What’s next year’s earnings looking like?’, Peter Jones asks with his chin pointing down to his notepad but eyes speculatively raised up at the entrepreneur.
From nowhere, an unexpected lollapalooza of a statement is blurted out. “Well Peter, I’ve got this *crumpled and dog-eared* letter from Ocado… Says here that they’d like to buy £500K worth of our bespoke, beautifully packaged, sustainable, vegan, Joe Wicks endorsed, repurposed, socially responsible, carbon footprint-free cookies”.
Peter Jones looks smugly across to his fellow Dragons – The querulous Scottish man is clenching his jaw trying to mask his frustration at missing out at such an opportunity, but the blood trickling from his nose gives the game away.
And that’s the point.
Trailing P/E ratio doesn’t tell you anything of value.
Nothing we don’t already know.
Big market players who ultimately move the market are incredibly forward looking.
‘The market’ doesn’t give a toss about the here and now, at the bare minimum it’s looking several months ahead. Years even.
When a company reports earnings, any shock move in the share price happens based on previously set expectations rather than how it compares with previous actual earnings.
Expectation is the key word; a forecast builds a perception and perception is greater than reality.
If Amazon increase earnings by 40% vs the previous quarter but Goldman Sachs analysts were anticipating an 80% increase, then I’m afraid it’s squeaky bum time for those Amazon investors.
Now that I’ve deemed trailing P/E ratios totally useless (and you may disagree), what’s next?
As per my fictional scenario, Peter Jones looks for future potential – and so should you!
At the very least, start with a forward P/E ratio if you like (instead of trailing P/E). Price to estimated forward earnings which you can use to compare same-sector listed shares.
Go one step further if you’re feeling fancy and critique the PEG ratio (Price-to-Earnings/expected EPS growth).
It’s important to distinguish between trailing and forward P/E as they can often tell a completely different story and in nearly every instance, the quoted P/E ratio which you read about will be based upon the trailing version.
So, know the difference and seek out the more comprehensive forward P/E.
I specifically mention PEG ratio because understanding future growth potential was a big turning point in my stock picking success.
It suddenly makes matters very relevant and looks at estimated growth rather than trailing numbers.
By no means should this be your only yard stick, but it’s a superb starting point to build upon.
Hopefully this sets you on a better path.
Valuation metrics have certainly served me very well over the years and there’s so many, easily accessible, ratios to read through.
Be it ROCE (Return on Capital Employed) which gives a great insight into capital intensive companies like miners or Quick Ratio (determines a company’s cash position vs liabilities due within a year) which can quickly expose a cash flow problem.
I hate having to trawl through income and balance sheets, so I let ratios do most of the heavy lifting and it gives me an instant snapshot of a company’s health.
I think the most important takeaway here is to actively seek the full picture before jumping in feet first.
Any stock I like the look off, I go on a mission to try and dis-prove my thinking. At the very least, I need to find potential risks and reasons why I’m wrong.
If I can’t find anything, then I probably haven’t dug deep enough.
Important information: When investing in shares, your capital is at risk. The value of the investment and any income from it can fall as well as rise, so you may get back less than your original investment.