Research P/E Is Not a Magic Number, Part II

By Zeke Ashton (TMF Centaur)
March 30, 2000

In my last article in this space, I discussed the limitations of the traditional price/earnings ratio and why it is not a magic number for investors to rely on in evaluating relative value. As I discussed last time, the P/E ratio is particularly distorting when used to analyze companies that have lots of debt, lots of cash, or that intentionally manage their businesses to maximize cash flow instead of reported earnings.

Today, I'd like to continue in the same vein in discussing other types of companies whose P/E ratios tend to tell investors a misleading story.

Companies That Are Growing Quickly
This would seem to be an obvious problem. Since the classic P/E ratio is calculated by taking the past 12 months' earnings, companies that are growing rapidly will look dramatically overpriced relative to their true economic value. This is a basic problem with most traditional value ratios: They are, by nature, backward looking. As investors, we need to be looking forward. One way to mitigate this limitation is to use forward P/E based upon the likely earnings in the next 12 months instead of the more standard P/E utilizing trailing 12 months' earnings. Of course, investors are then faced with uncertainty regarding the next 12 months' earnings. While analysts estimates from such providers as First Call or Zack's can be useful here, there is obviously nothing certain about the future. Still, imperfect or not, companies that are growing quickly need to be viewed differently from those are growing at a more moderate pace, and the P/E ratio treats both companies alike. Using a forward P/E with best guestimates of likely future earnings in addition to the old standby will tend to be better than using traditional P/E alone.

Fast-growing companies will often provide another challenge when viewed from the myopic lens of the P/E ratio. Because these companies often are in a race against competitors to build out infrastructure and acquire new customers as fast as possible, they tend to plow a large portion of their sales revenues back into the business in the form of capital expenditures; purchases of plant, property, and equipment; hiring of new personnel; or research and development of new products. These activities all depress earnings in the short term, while of course increasing likely earnings several years out. Companies that effectively achieve scale early in their lives at the expense of earnings will be worth much more than companies that emphasize earnings and therefore do not achieve sufficient scale in their business. An investor who is over-reliant on the P/E ratio will often fail to see the value inherent in the first business due to the all-encompassing emphasis on current earnings.

Companies That Have Recently Achieved Profitability
As companies like Yahoo!, AOL, and Amazon are proving, building a global business to scale takes several years of sustained losses before turning the profitability corner. Yahoo! and AOL have successfully turned the corner, while Amazon has not reached the profitability stage of its lifecycle. Because Yahoo! is still very young in its growth cycle, the company has very little in profits relative to where it will be when it begins to hit maturity. Using the P/E ratio to analyze companies that have only recently turned profitable is usually a total waste of time, because the number will be meaningless (as well as astronomical). Many a popular financial publication has decried the valuations of Yahoo! and AOL in the past two years by pointing to the relationship between market cap and earnings. It is a testament to the intelligence of the market that the stock price of a ground-breaking company like Yahoo! has risen in accordance with the company's flawless execution and the expanding possibilities offered by the business model despite the constant battle cry of "overvaluation" offered by the mainstream financial press.

Companies in Cyclical Industries
As longtime investors in such cyclical industries as automobiles and energy can tell you, a company in a cyclical industry may quixotically display a contraction in the P/E ratio after a fantastically profitable year, and an expansion of the ratio after a poor year. This is because longtime investors know that a company like Ford will absolutely clean up when the economy is rolling, interest rates are low, and consumer confidence is high. The same company will often show little profits or even losses during a recession. Companies like Ford make a killing and pile up the cash at the top of the business cycle, and then live off those reserves to sustain operations during the lean times at the bottom of the cycle. Because of this, savvy investors price the inevitable bad times into the stock. A fledgling investor can get killed by investing in a company like Ford at a low P/E, which is probably a signal that investors expect the economy, and Ford's profits, to turn down in the near future. Historically, the time to buy companies like Ford is at the end of the down cycle just before an economic upturn. At those times, these companies will often have very high P/E ratios because investors realize the company has value despite the occasional periods of very low profitability.

Companies With No Profits
Since I'm trying to be comprehensive in my coverage of the P/E ratio, we might as well mention the most obvious limitation. For companies with no earnings, there is no P/E ratio. Does that mean that a company with no profits has no value? Obviously, if you look at a company like Amazon.com, valued by the market at over $20 billion, the answer is a resounding no. Companies certainly do have value before they have profits, although there must be reason to believe that they will eventually turn profitable. Unfortunately, investors that have trained themselves to over-rely on the P/E ratio often have little else in the way of an analytical framework to evaluate a company, and those without profits become a total mystery to them. Of course, an investor can simply refrain from investing in companies with no profits, but this should be a matter of choice rather than a decision born of the lack of the ability to evaluate unprofitable companies.

How to Use the P/E Ratio
We've now cataloged the types of companies for which the P/E has important limitations. Let's review the list:

  • Companies with lots of debt.
  • Companies with lots of cash and no debt.
  • Companies that grow quickly.
  • Companies that have recently turned profitable
  • Companies in cyclical industries
  • Companies that haven't achieve profitability
You can see why those investors who have clung to the P/E ratio as their only gauge of value have probably missed out on some good returns in the past several years. The pool of companies that remain after the process of elimination above is pretty limited. In short, mature companies in mature industries with consistent and very predictable profits are the ones for which valuation analysis using the P/E ratio is most appropriate. It just so happens that those companies aren't the ones that the market has been falling over itself to buy in the past couple of years. Does this mean that the P/E ratio doesn't offer any value to investors? Absolutely not. It's just that investors need to be familiar with its limitations, and make adjustments in the framework of their analysis. The use of other valuation concepts such as enterprise value, projected forward P/E ratios, and other analytical tools can increase the amount of information available to the investor. The P/E ratio should serve as only one data point among many in a Fool's analytical toolbox.

Related Link:

  • P/E Is Not a Magic Number, Part I