FOOL ON THE HILL
P/E ratios give investors a sense of how the market is valuing its earnings, but it leaves out much that is critical when it comes to actually valuing an asset, namely a premium for risk and the time value of money. Luckily, there are a number of tools investors can use to improve their understanding of a company's valuation.
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Anyone who reads the business section of a newspaper can provide a quick definition of the price/earnings ratio. You take the price of a stock, divide by its trailing 12-month or forward earnings, and just like that you've got one way to look at the "value" of a stock. But the P/E formula most folks know is actually a simplified version of the dividend discount model, which matters only in that the P/E ratio is a shortcut valuation technique that omits more than it includes. Specifically, as Credit Suisse First Boston analyst Michael Mauboussin has said, the P/E ignores risk and the time value of money. It also wrongly assumes a one-year snapshot of earnings is representative of the company's sustainable earnings power. That's a lot of important luggage left behind. As a result, eyeballing a company's P/E ratio to determine its value is a little like trying to figure out how much a car is worth by sampling the exhaust. That doesn't mean P/Es aren't handy. Like most widely used benchmarks, P/E ratios have something of a life of their own. They can give you a sense how the market views a company -- and a sense for how much the market, an efficient instrument in the long term, has been willing to pay for a dollar of the company's earnings over a period of time. You can easily see that investors don't value $1 of earnings from IBM (NYSE: IBM) the same way as $1 of Microsoft's (Nasdaq: MSFT) because they value Microsoft's growth prospects and ability to generate a return on its investments more highly than IBM's. There's an important economic lesson there, and in a broad sense the P/E ratio gets us talking about some of the right things. But it's a surface measure. I think of P/E ratios a lot like dollar bills. They give us an easy reference point, a useful unit of account, but the value is really derived from a multitude of internal factors, not by the denomination slapped on the front of the bill. The P/E is a reflection of what the market thinks about a company's value, not the value itself. As such, it will change according to internal factors -- just as the real value of $1 changes with inflation, interest rates, the economy as a whole, and independently based on its relationship with other currencies. To understand where the P/E ratio came from, and get an inside look at what's lacking, you have to know a few things about asset valuation; just the basic brushstrokes. If you want to value an asset you need an estimate of its future cash flows, and a required rate of return. Why? The cash part is pretty simple. A company is worth the cash it creates for shareholders, either in the form of dividends or stock price appreciation. The required rate of return for common stock is a little more difficult, but it incorporates the time value of money, a baseline return, an adjustment for inflation, and a risk premium. These are bedrock concepts investors should understand. The time value of money expresses the concept that $1 a year from now is worth less than $1 today: I can't use $1, delivered a year from now, to buy an ice cream cone today. In addition to the loss of immediate consumption value, other factors -- such as inflation, which chips away at the buying power of $1 -- play a role. These factors commingle to make the present value of $1 received one year from today worth less than $1 dollar. I'll demonstrate how it works down below. As for risk, it's an important component of an investor's required rate of return because the future cash flows of any stock are uncertain. Just because Cisco's (Nasdaq: CSCO) John Chambers tells us sales will grow 30% to 50% per year for the next five years doesn't mean it's going to happen. As investors, we must be compensated for this risk. The basic formula to value common stock is the dividend discount model. It's called this because dividends, quite literally, represent cash flows. Stock investors must abstract things a bit by regarding earnings growth (or cash flow growth) as equivalent to actual cash flows, but, heck, we have to work with something. And since dividends are based on earnings, it's not too much of a leap in logic to value earnings rather than the resultant dividend -- though it does require a leap of faith. If we put these elements together, we can get a look at the mechanism of discounting, which is just the opposite of compounding, and an exercise we must perform to value any asset. Remember when I said $1 a year from now is worth less than $1 today? We can illustrate this mathematically with a simple formula: This reads: The present value of that dollar equals $1 divided by the sum of 1 and R, raised to the Yth power, where R represents the required rate of return and Y represents the number of years into the future that you are projecting. Say we demand a 10% return on our $1 investment. Using the above formula, we can see that the present value (today's value) of $1 received one year from today at a 10% discount rate equals $0.91. The discount rate used to value the average common stock includes more than what we see in the dividend discount model, but it gives you an idea of what's happening. Just look at the top and bottom of the equation. In the numerator we have earnings -- the cash flow part of the equation. In the denominator we have the discounting engine, which incorporates the time value of money, a baseline return, and risk premium in a neat little mathematical package. So the P/E ratio is actually related to the dividend discount model. The problem is that in its simplest form --price divided by earnings -- there's no discounting, no risk premium, no estimate for growth, no allowance for the fact that any set of annual earnings figures may be an aberration, and no reflection of the fact that earnings are based on accounting assumptions. In other words, the meat has been stripped from the bones and all you're left with is a skinny formula that reflects a simplified relationship. Kin of the P/E ratio, such as the price/sales and price/book value, suffer from the same malady. The price/free cash flow ratio, for example, corrects for some of the accounting wizardry we see in earnings figures, but it's still a very one-dimensional representation of a company's value since there's no discounting and no accounting for risk. Does this mean we should scrap P/E ratios? No. Just understand you need a number of tools to begin valuing an asset. Using nothing but P/E ratios is like showing up for a three-alarm fire with a Slurpee. Beginning investors don't have to digest all this information at once. But by understanding a few basics -- future cash flows, discounting, and risk -- we can open our valuation horizons a bit, and start looking beyond P/E ratios to other concepts that do measure value, such as return on invested capital. Have a great day. Richard McCaffery is a man who, like Tio Sancho, knows tacos taste better in your mouth than on your shirt. His stock holdings can be viewed online, as can the Motley Fool's disclosure policy. PV = $1/(1 + R)^Y.
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