P/E Is Not a Magic Number, Part 1

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The answer to this question is that in doing our analysis, we take a lot of variables into consideration. While the P/E ratio is certainly a data point that we look at, for most of the companies we cover, it won't be of great importance. While the P/E ratio has its value in securities analysis, it must be applied in a reasonable manner. An investor who takes a quick look at a business, slaps the P/E ratio on it to measure its relative attractiveness, and then makes an investment decision based on that one piece of information is likely to be disappointed with his portfolio's performance. In this article, I'll explain why P/E is not the best tool to use in the analysis of many companies, why it is irrelevant for many others, and how a Foolish investor can tell the difference.

Let's start by going back to the basics. The P/E ratio is calculated by taking the company's market capitalization and dividing that by the its last 12 months earnings. Why is the P/E ratio of interest to investors? Despite its simplicity, this ratio does provide a lot of information. For one thing, the P/E ratio tells an investor how many years it will take to earn back his principal in company earnings, assuming earnings remain constant. For example, if Company X has a P/E of 14, it would theoretically take that company 14 years of identical earnings to earn the investor's principal back. Another way to look at the ratio is the cost for each dollar of the company's earnings. Considered this way, the investor is paying $14 for each dollar of earnings produced by Company X in the past 12 months. This measure allows an investor to compare the relative price tags of two different companies.

By using the reciprocal of the P/E (dividing 1 by the P/E), an investor can also determine the relative earnings yield of his or her investment in percentage terms. For example, taking the formula (1/PE) for Company X yields 7.1%, which is what the investor theoretically earns on each year of identical earnings. Our investor can then compare this number directly to bond or money market yields. All of these uses for this one simple ratio make the P/E a valuable tool. The problem with the P/E is that many investors try to use it as a single magic number against which all investment decisions are measured. This is inappropriate, because while the P/E ratio has some value, it is somewhat limited.

Why? Well, the ratio tends to lose a lot of its value when dealing with certain types of companies, either understating or overstating their attractiveness. Let's take a look at some examples.

**Companies With a Lot of Debt**

Because the classic P/E uses market capitalization to represent price, the ratio can dramatically understate the actual economic cost to purchase shares of companies with a lot of debt. Economically, of course, any debt would have to be assumed by the purchaser of the company, and therefore adds to the price. One example is **Toll Brothers** (NYSE: TOL), a very well-run housing builder. In a recent "Stock Talk" interview with Robert Toll, CEO of luxury homebuilder Toll Brothers, Mr. Toll made the following statement in describing why Toll Brothers would be an attractive investment.

TMF:Why should long-term investors be interested in a company such as Toll Brothers?

Toll:One of the best aspects of Toll Brothers is that the past, while it's no promise of the future, is a pretty strong indication of where we'll be. It appears that during the '90s, we've had approximately 25% compounded growth in both revenues and earnings. On a nine-year basis, on a five-year basis, on a three-year basis, [or] any way you slice it, Toll Brothers is on a growth scale greater than General Electric for the same period of time. And yet, we have a multiple of under 7 [times earnings] now, and General Electric has a multiple of something like 40. Now I'm not suggesting that this company of ours is to be compared with General Electric. But in terms of growth, it certainly has proven itself as capable, even more so [than General Electric]. Our graph looks better than theirs.

On the face of it, Mr. Toll makes a convincing argument. If you look at the company, you'll find that the P/E is indeed under 7 with a market cap of about $666 million. But Toll Brothers has an additional $682 million in debt, meaning that the actual economic price of the company is about double the market cap. Therefore, on an enterprise value basis, the company is selling at closer to 14 times earnings. In this case, the P/E ratio understated the price of the company by half, and while Toll Brothers is a good company, investors who don't understand this are probably not getting the value they thought when they purchased Toll Brothers shares.

**Companies With Lots of Cash and Little or No Debt**

While the P/E ratio understates the price for companies with a lot of debt, for companies that have lots of cash and no debt, the P/E ratio can dramatically overstate the price of the company. Because any cash that a company carries beyond its operating needs could theoretically be paid out to shareholders or simply taken out of the business by an acquirer, the true economic price of a company must be adjusted by this amount. There are many companies that carry the equivalent of a quarter of their market cap in cash and investments, and the P/E ratio for these companies would appear to make them less attractive than they really are.

Of course, the distortions in the P/E ratio can be easily mitigated by using enterprise value instead of the market capitalization as the numerator in the P/E calculation. Enterprise value is calculated by subtracting cash and short-term investments from the company's market cap, and then adding any debt. The use of enterprise value requires more work on the part of the investor, but can potentially make a big difference in the investment decision.

**Companies That Are Operated to Maximize Cash Flow and Minimize Reported Earnings**

This brings us to the "Earnings" side of the equation. Because earnings refers to GAAP accounting earnings, this ratio will generally understate the value of companies that operate to maximize free cash flow and minimize reported earnings. Why would a company do this? Simply put, because the more the company can reduce its reported earnings, the less tax it pays. Assuming that the cash flow generated by two companies is identical, the one that reports the lower amount of accounting earnings, all else being equal, is going to be worth more to its investors. This is because the company will be either paying less in taxes, or deferring taxes to future years. A company with lower taxes will therefore free up more capital to build the business or return to investors.

Companies that have a large discrepancy between cash flow and earnings will have P/E ratios that distort their values. For example, for the four quarters of 1998 and first three quarters of 1999, Yahoo! reported a total of $42 million in earnings. Over the same period, the company produced over $285 million in free cash flow. Investors relying on the P/E ratio to give them an accurate idea of the company's profitability would be missing one of the company's biggest strengths. On the other side of the coin, companies that consistently report higher earnings than free cash flow will sport more attractive P/E's than economic reality may warrant.

That's it for today! I'll be back with Part 2 of this discussion about the proper use of the P/E ratio next week.