Attention Investors: The P/E Ratio Revisited

In a recent episode, Industry Focus: Tech discussed how deep-value investors can use the P/E ratio to help make better investments. This week, Dylan Lewis and his guest John Rotonti look at how investors on the other end of the spectrum can use the ratio to buy into companies that are undervalued for the long-term potential they offer.

Tune in to find out what the P/E ratio means for quality-focused investors, a few metrics you might want to use in your stock-buying checklist, what makes Apple (AAPL 0.34%) and Accenture (ACN 0.30%) such fantastic and undervalued companies for long-term quality investors, and more.

A full transcript follows the video.

This podcast was recorded on Jul. 1, 2016.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, July 1st, and we're talking tech and value investing. I'm your host, Dylan Lewis, and I'm joined on Skype by Motley Fool Premium analyst John Rotonti. John, how's it going?

John Rotonti: I'm doing good, Dylan. How you doing back at headquarters?

Lewis: Doing alright. It's Cake Day here, so I'm pretty excited.

Rotonti: Oh man, I miss Cake Day!

Lewis: Yeah, it's one of the worst parts about being remote, I guess, right? You don't have Cake Day or Pizza Day.

Rotonti: It's right up there at the top of the list, for sure.

Lewis: Earlier this month, I did a show on the price to earnings ratio, the P/E ratio, with Fool Premium analyst Simon Erickson on that episode. It's called Tech: All It's Cracked Up to P/E? You'll have to excuse the pun, if you want to try and find that in the archives. Simon is a high-growth investor, and he thinks about valuation a little bit differently than some folks do.

After doing the show, I realized not every investor has the same time horizon or the risk appetite for that type of approach, so I want to do a show detailing another way to think about P/Es and valuation. Thankfully, John Rotonti, who's one of our Premium analysts for Inside Value and Motley Fool One services, was happy to serve on the show and help me break it down. John, thank you so much for waking up early in Colorado so you could Skype into the show. Before we get too far into things, do you want to give some background for our listeners? Just a little info on who you are and how you got here.

Rotonti: Sure. Really happy to be on the show, thanks for having me. I actually celebrated my two-year Fooliversary a few days ago; I've been with the Motley Fool for two years. Before that, I got an MBA from Tulane University. I worked on Wall Street for a while, then I served for three years as a fellow at the Mario Gabelli Center for Global Security Analysis, so, obviously a legendary value investor there, I learned tons working there. I wrote a book at one point in time, back in 2013, it's called A Manual on Common Stock Investing, just a really introductory-level look at what the stock market is, what a stock is, and maybe some ways to invest in the stock market. And I've been at The Fool for two years now, and I love working on Inside Value and Motley Fool One.

Lewis: It's funny, John, I actually just celebrated my two-year Fooliversary as well, because we started work on the same day.

Rotonti: Yes we did! Congratulations! I remember going out to a new Fool lunch or something on that first day. I remember it clearly.

Lewis: Yeah, it was me and the [analyst development program, or ADP,] cast, which was a lot of fun. John, you obviously have a lot of value credentials. You've certainly spent your time honing your investing craft. Can you start a little bit explaining your mentality when it comes to investing, and how you think about it?

Rotonti: Sure. I actually started when I was a freshman in college. I'm 35 now. So it's been a while. I think my strategy has shifted over time. At one point, I was what I would consider a traditional deep-value investor. Now, I've shifted more to focusing on high-quality companies. 

I guess one thing is, there's a value spectrum. On one side of the spectrum, you have traditional deep-value investors looking to buy the proverbial dollar for $0.50. On the other end of the spectrum, you have the Warren Buffett and Charlie Munger style, which is that they're willing to pay a fair price for a great business if they think that business can increase its intrinsic value over time. Using the same example, the deep-value investor wants to buy $1 for $0.50, and then they'll most likely sell it as it approaches that $1 value. A quality investor that's willing to pay a fair price will pay $1 for $1 of value today if they think that business will be worth $2, $3, $4, or even $5 down the road.

So there's a nice spectrum there. The deep-value folks, they've been super successful. It works. A lot of them have really generated a fortune for themselves over the years. The quality end of the spectrum works, as well. I'd say the deep-value folks focus more on the margin of safety, and the other end of the spectrum focuses more on the size of the moat, or the competitive advantage.

Over time I've probably shifted, but I'm definitely always looking for value, for sure.

Lewis: To contextualize that spectrum and the differences there within the value investing niche, within the P/E ratio: I think when you're talking about the deep-value, cigar-butt investing, you're looking more at companies that are, relative to the market, pretty cheap. Or, relative to competitors, pretty cheap.

Rotonti: Yep.

Lewis: Whereas, if you're thinking more about quality businesses, these might be businesses that are trading above market P/Es, but the opportunity there is maybe being undervalued by the market in the eyes of the investor.

Rotonti: That's exactly right. If we just take a step back and think about what the price to earnings ratio is...I think a good way of looking at it is: How many years would it take an investor to break even, or make back their original investment, if earnings remain constant? If you have a stock price of $10 per share, and earnings per share of $1 per share, that's a P/E of 10, and we assume that earnings will remain at $1 per share -- so no growth in earnings -- then it would take 10 years to break even.

Lewis: And that's not including time value of money, and all that other stuff. A simplified version of that line of thinking.

Rotonti: Really simplified version, exactly right. All else being equal, if you can find two companies of equal quality, and with equal growth and margin profiles, a lower P/E would be better. That's the first thing I'll say. The second thing is maybe that, as investors, we can't examine a P/E ratio in a vacuum. It has to be compared to something, whether it's the company's growth rate, whether it's the company's returns on capital -- or whether it's to a market multiple, a pure multiple, or the company's own historical multiple. It's relative to something.

And then, I'll say that companies with higher growth, more predictable growth -- so not a lot of cyclicality in the business -- and higher returns on equity, tend to trade at higher P/E ratios, just like you said. The flip side of that is companies with slower or deteriorating growth, cyclical earnings -- not a lot of predictability -- and lower returns on equity tend to trade at lower P/Es. Since I tend to follow companies that are not cyclical and have higher returns on equity, most of the companies I'm actually researching, even for a value investor like myself, tend to have either market or above-market P/E ratios. So yeah, that may come as a surprise, but that's where I'm focusing now.

Then, just for reference, the S&P 500, which is typically thought of as a proxy for the stock market, is currently trading at 24 times its last 12 months' earnings, and 18 times forward earnings. Those are two rough benchmarks I'm using when looking at P/E ratios.

Lewis: John, I'm glad you brought up ROE before. I think any time I have an investor talk about how they think about investing, the structure, it's always important to say: What metrics are you looking at; do you have a checklist-type approach? Or, what's the lens that you are looking at these companies through -- is ROE one of them?

Rotonti: ROE is definitely one of them. I do use a checklist when I'm both investing for myself or recommending companies to either Inside Value or Motley Fool One. In general, I tend to focus on companies that I understand, one; companies that I admire, two; and then, companies that I consider of the highest quality. I'll define quality briefly as: companies that generate high returns on equity and high returns on capital over a long period of time, and I think have the ability to continue to generate those high returns into the future. So, that's one indicator that the company has a competitive advantage, protecting its economics from the competition. Return on equity is definitely one of the ones I look for.

I look for companies that generate a lot of free cash flow, and that have a management team that intelligently knows how to allocate those free cash flows, either into reinvesting back into the business at high returns on equity, or returning money to shareholders through dividends or smart share repurchases. And then I look for strong balance sheets.

Lewis: Maybe to illustrate some of the traits you're looking for, why don't we talk about a couple of companies currently on your radar, or a couple examples of what you think to be really great value investments? When we were talking before the show, you said you wanted to talk about Apple and Accenture. Why don't we hit Apple first? Forrest Gump's favorite fruit company: it's one of those stocks that have been perpetually cheap since about 2009. They're currently at a trailing P/E of about 10.5, roughly half that of market right now. When you're looking at this company, what makes them a value investment for you, John?

Rotonti: Dylan, I love how you teed it up, because you said it has been perpetually cheap since about 2009, which means that maybe I'm missing something; maybe the market's right. It's definitely possible, it's happened before, and it will definitely happen in the future. I guess the question is, and it's a question that value investors struggle with a lot: is something cheap, is it undervalued, or is it a value trap? 

When I think about Apple, actually, I see a lot of pattern recognition with another company trading at a low multiple of earnings, which is Gilead [Sciences] (GILD 0.64%). I know Gilead...technically it's not tech, but it has tech in its industry title, because it's biotech, so I'll bring it up really quickly. From a pattern recognition standpoint, both Apple and Gilead have superstrong balance sheets; both have generated a ton of free cash flow, have high returns on invested capital. Both have superhigh market share. Apple has about 14% share of the global smartphone market, but it generates more than 90% of industry profits. Gilead has about 70% market share of the HIV market, and 90% share of the hepatitis C market in the U.S. So, really established dominant businesses. Both have what I believe to be high-quality management teams. Both pay an almost identical dividend that yields 2.3%. And both are statistically, optically cheap, trading at less than 10 times enterprise value to free cash flow. 

But, on the other hand -- and here are more similarities, and these are big "buts" -- both generate a majority of the revenue from one or two products. For Gilead, I think 90% of its sales come from its treatments for hepatitis C and HIV, and for Apple, I think the iPhone accounts for about 2/3 of its sales. Both do not have a lot of revenue diversity, both are facing slowing growth, and both are facing some degree of pricing pressure. So the question is, are they good investments? Are they value traps? I admire both companies. I actually prefer Apple, and I'll talk a little bit more about Apple, primarily because I just understand it better. At this point, I have not really dived into Gilead's pipeline. I don't yet know how to value it. So it's high on my watch list, but I'm focusing on Apple, and I have an investment in Apple.

A few more reasons. I think it trades at the low multiple that you mentioned because maybe a lot of investors think of it as a hardware company. And I just mentioned that 2/3 of its revenue comes from the iPhone. But, it has got four fantastic software platforms that users love. It has one for the iPhone and iPad, one for Macs, one for the TV, and one for the Watch. So it has definitely got a great accompanying software portfolio there. Then, the cool thing is, it has got these continuity functions. The iOS software can talk to Mac software, so you can start an email on your iPad and finish it on your Mac, and do lots of other continuity functions, which I think is so cool. It has a growing stream of high-margin recurring services revenue. It is rapidly growing its enterprise business through partnerships with IBM, SAP, and Cisco. 

I think the question becomes: Does the iPhone lose its pricing power and just become a commodity? And I think, if we think about the iPhone or any other Apple device as the admission ticket into the Apple ecosystem, then the company will be able to maintain its pricing power. There's no other way to access the over 1 million apps in the App Store, or iTunes, or Apple TV or Apple Pay or iCloud or HomeKit or HealthKit or CarPlay. You just can't access that without an Apple device. So if people want access into that ecosystem, they have to pay a price. So I think they're going to be able to maintain that pricing power.

And then Apple has amazingly loyal customers. It has an installed base of over 1 billion devices around the world. If you think about that for a second, it has nearly as many Apple devices out there as there are Facebook accounts, yet Apple devices cost hundreds of dollars. Another sign of that loyalty is Apple's customer retention ratio in the 85%-90% range.

Then you start looking at the numbers. I mentioned it has high returns on capital and free cash flows. It has got $150 billion in net cash. It will have returned $200 billion to investors by early next year, through dividends and buybacks. Then, that cash position, that balance sheet, it provides it with a lot of optionality. I mean, I'm not smart enough to know what Apple is going to do next, but with $150 billion, I bet it's going to be pretty cool. At least that's a bet I'm making. Are they going to get the Watch to really catch on? Is the TV going to catch on? Is the Apple Car going to catch on? Are they going to buy Tesla? I don't know, but they have a lot of firepower to do it.

Lewis: And to point to another potential growth driver, penetration in emerging markets is still pretty low, and the infrastructure to support smartphones in the hands of every consumer in a lot of those emerging markets, your Chinas and your Indias, are still very low. So there could be a huge ramp there.

I will say, John, I'm with you on Apple. I'm a shareholder. Even if they don't meaningfully grow the business, and manage more to just hold a steady state, you're enjoying a dividend yield of over 2%. They've upped their quarterly dividend recently: 10%. That's the fourth time in four years they've done that, and I think that's just going to continue. And lastly, they have a huge share buyback authorization, and they've executed very well and done a lot to return value to shareholders. I think you have to be happy about all that.

Rotonti: I couldn't have said it better myself, Dylan, thank you! And like I said, they're going to return $200 billion by early next year. When you're buying back shares at 10% free cash flow yield, that's compared to the risk-free rate, which I read this morning, actually, is at an all-time record. The 10-year U.S. Treasury bond is at 1.4%. So, you compare a 10% yield to that, or, even if you compare it to the free cash flow yield on the S&P 500, which is about 5% right now, I'll take my chances there.

Lewis: Yeah. Switching over to another tech player, John. You said you also wanted to talk about Accenture. This is a company that's probably most easily understood as a consulting company, but they have their hands in a whole bunch of different things. You want to talk about their business a little bit?

Rotonti: Yeah, thanks, I'd love to! What I like about Accenture is, it's a way to invest in some of the most exciting technologies in the world, without having to pick who's going to be the winner, or what's going to be the next big thing. There's handfuls of cloud companies out there, handfuls of cybersecurity companies out there; for me, it's hard to pick which one's going to be the winner. But with Accenture, they help their clients implement cloud computing or cybersecurity. So they're going to benefit from the industry tailwinds, regardless of who turns out to be the winner.

You mentioned it's a technology consulting and outsourcing company. It's got a strong balance sheet, again, with $3.5 billion more in cash than it has in debt. It has got strong free cash flows. It generates 50% returns on equity -- there's that ROE number again. And then, the predictability and consistency that we talked about earlier: It's increased revenues in 16 out of the past 18 years; the revenue growth is not always really strong, but it's consistent. I think in the past three years, if you look at 2013-2015, revenue grew at about a 4% CAGR, which is not bad in a slow-growth world. But it's increased constant currency revenue growth by double digits now for seven consecutive quarters, and it's guiding for full-year revenue growth this year of at least 9.5%. So it's coming off of 4% revenue growth rate, and that's ramping up to double digits.

What's happening is Accenture is perfectly positioned to take advantage of the new industrial revolution that we're seeing with cloud, cyber, and social and mobile. In fact, those businesses now account for 40% of Accenture's total revenue, and they're growing at a 30% clip.

Lewis: Just to clarify, when you say CAGR, for listeners who might not know, that's compound annual growth rate.

Rotonti: Yes, basically average growth rate annualized out over a period of time, compound annual growth rate, exactly right. 

You have got this company with a huge competitive advantage, great management, rock-solid balance sheet, and it just has a ton of business momentum right now benefiting from this new industrial revolution. And then to top it off, it's the 38th most valuable brand in the world according to BrandZ. The CEO has 93% approval ratings on Glassdoor.com; 94% of the Fortune 100 are its clients, and its client-retention ratios are off the charts, so of its top 100 clients, 97 have been clients for the past 10 years. Fourteen consecutive years as one of Fortune's "Most Admired Companies," seven consecutive years as one of Fortune's "100 Best Companies to Work For," nine consecutive years as [one of] Ethisphere's "World's Most Ethical Companies." So, you're getting all of that at what I think is a fair price, and I'm happy to be an owner right now.

Lewis: And currently, they're at a P/E of just under 20. They're an international company, they're headquartered in Ireland. They were a company that was hit particularly hard by the Brexit news because of that. They've rebounded a bit. They're still down about 5%, but it seemed like an opportunity for people that might be interested in them. If you're interested in following up with Accenture, John, are there any important metrics to look at? I know their business is a little bit different than what we might typically talk about on the tech show.

Rotonti: There's a unique metric in the consulting industry that Accenture reports every quarter when it releases its earnings; it's called the book-to-bill ratio. It's basically an indicator of future demand, so it measures new orders relative to actual business performed and billed. So, a ratio of 1 times or higher is generally an indicator of strong future demand. 

Beyond that, I look at returns on capital, free cash flow relative to both its reported net income and its sales, and I look at its growth rates. Like you said, it's domiciled in Europe, it got hit a bit with the Brexit news. But that's maybe an opportunity for long-term owners to either add to their position, or for people who are interested to maybe take a first look.

Lewis: Awesome. You know, John, while you're remote now, you were at Fool HQ for a while, and on Fridays, you know, we'll occasionally have tours come in. We actually just had one stop into the studio. And we have a long-term IF listener who seemed very eager to ask a question. We don't normally do this, do you mind if he comes in the studio and just sees what you have to say about something?

Rotonti: I would love that.

Lewis: All right, here we are. You mind saying your name?

Simon Erickson: Ah, hey there Gene [sic], my name is Wilson Piquet, I'm from the city Altus, Arkansas. Really, really love your show! Thank you for all of the guidance that you have given me for the last 10 years at The Motley Fool.

Rotonti: Thank you, sir! Really glad to have you!

Erickson: A serious question for you, though, Jen [sic]. I've been listening to Dylan's show for a long time, and a couple weeks ago, he had, uh, some Simon Innovator -- he was on the show --

Lewis: Simon Erickson, yeah.

Erickson: Right, the Innovator guy. He was saying that P/Es that were high P/Es were better stocks to buy. But, from what you're saying, it kind of sounds like you're saying that the low P/E stocks are better stocks to buy, and I just wanted to ask you, Jan [sic], is the P or is the E more important?

Rotonti: Well, I'm not going to take the other side of an argument against Simon "Innovator" Erickson, that's for sure. But, like I kind of said in the beginning, I focus on what I consider to be that most...highest-quality companies in the world, and those rarely trade at low P/Es. So I'm in the Simon Erickson camp, for sure: both feet in the Simon Erickson camp.

Lewis: That was a very good answer for having something totally sprung on you. Listeners, if you can't tell, Simon Erickson decided to hop into the studio and have a little fun with John.

Erickson: My cover is blown, John!

Rotonti: Hey Simon, how are you doing?

Erickson: I'm sure you didn't know it was me the entire time.

Rotonti: I think I picked up on it about halfway. Great question!

Lewis: You know, even though you put on an accent, it still sounded exactly like you.

Erickson: I tried so hard to conceal! But cover is blown. John, I can't wait to at least look back on this video, at the first five seconds of your face, just to see if there's any doubt at all in your mind that it wasn't really me.

Rotonti: I think you'll see a big smile, and I maybe even cracked a laugh once I realized it was you.

Lewis: So, we're having some fun here in the studio, but I think these two different shows highlight the two different investing approaches we have here at the Fool, and our openness to thinking about things a little bit differently. I will say, Simon and John, for some of your differences, you do share some holdings. I was looking down at what you guys own at Fool.com, because all of our holdings are publicly available, and you're both TJX and Apple shareholders. I think maybe down the road, we can do a show profiling a couple things you both agree on, and some businesses you both really like, based on the two different lenses you use to look at publicly traded companies.

Rotonti: I would love that! I still remember taking my analyst development program class on innovation and disruptive companies from Simon. Any time I can chat with Simon about anything, I'm up for it.

Erickson: I'm up for it too. I'll speak in my natural voice, I promise. I also have a ton of holdings in my portfolio, too, that are more considered value stocks, just like the ones John has been describing.

Lewis: John, anything else? Thanks for being such a good sport. Any other things you wanted to point out before I let you go?

Rotonti: No. I'm grateful to be on the show. I'd love to come back on at a later date. I think, with the Brexit news right now, watch lists are really important. Do your research before an opportunity presents itself. Whether it's on Inside Value or Motley Fool One, or with Simon on MDP and Rule Breakers, we're trying to do our research months or even years in advance of when these opportunities present themselves, and then we're ready to make a buying decision when the time comes.

Lewis: Wise words to live by. Well, listeners, that does it for this episode of Industry Focus. If you have any questions or just want to reach out and say hey, shoot us an email at [email protected]. Or, you can tweet us @MFIndustryFocus. If you're looking for more of our stuff, you can subscribe on iTunes or check out the Fool's family of shows at fool.com/podcasts. We've also got a listener survey we'd love your help with. It'll help us serve you better. It'll take just a couple of minutes, and you can do it anonymously. If you want to help us out, we'd really appreciate it. The survey is online at fool.com/podcasts.

As usual, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell based solely on what you hear here. For Simon Erickson and John Rotonti, I'm Dylan Lewis: Thanks for listening and Fool on!