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How Useful Is the P/E Ratio?

By Chris Hill – Updated May 17, 2021 at 4:58AM

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"There is only a limited time during the life of a company when a P/E ratio is truly useful."

In this episode of MarketFoolery, Chris Hill chats with Motley Fool analyst Jim Gillies about the latest headlines from Wall Street. They answer a couple of listeners' questions. They talk about investing in solar stocks and ETFs. As retail earnings season is about to begin, they bring you a little bit of an earnings preview and much more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

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This video was recorded on October 19, 2020.

Chris Hill: It's Monday, October 19th. Welcome to MarketFoolery. I'm Chris Hill. The Public Safety Minister of Canada says that the U.S.-Canada border is closed to all nonessential travel until November 21st. So, joining me from his home in the province of Ontario, in the city of Guelph, it's Jim Gillies. Good to see you, my friend.

Jim Gillies: Good to be seen.

Hill: I always feel like seeing you is essential, but look, I'm not going to argue with the Public Safety Minister of Canada. Investing in solar energy, that is a topic we're going to hit today. We're going to do a little bit of an earnings preview, as earnings season starts to kick off this week. Let's dip into The Fool mailbag; [email protected] is our email address.

A great nuts-and-bolts question from Isaac Hemingway, who writes, "I was just wondering, how do you calculate a company's ratio when the company's net income is negative? Is it even possible to calculate?"

Thank you for that, Isaac. For those unfamiliar, the P/E ratio, the price-to-earnings ratio, may be the most often looked to ratio [laughs] when it comes to investing. As we've talked about before, Jim, not always the best one to look at depending on what industry you're investing into, what company you're looking at. But to Isaac's question, what do you do when there's no earnings, per se?

Gillies: Well the answer -- and, Isaac, it's a great question, and you're going to allow me to get my investing valuation wonkiness on here. The answer is, you get a negative number, a negative ratio. Now, I think perhaps the question you should be asking is, is the ratio worth calculating? And when you have negative earnings, I would suggest that unless there's been like a one-time write down perhaps of a failed acquisition from a few years ago, where they wrote down goodwill that stem from that acquisition. If it's driven by a one-time item you can just back out the item and try to, you know, kind of, back in to a number.

But this is a more broader question, Isaac, that you've given us here, if I may. And I would suggest that there is only a limited time during the life of a company when a ratio is truly useful, frankly. And I will state, I don't use ratios much, if at all; I prefer other valuation ratios, I prefer discounted cash flow methods, but I would suggest that a company -- you know, if you think of a company as having a lifecycle like any other thing, whether it's humans, governments, whatever. We all have kind of a -- we're born, we grow, we have a mature phase, and then we tail off to oblivion. And in the lifecycle of a company, I would suggest that once the company is -- like, from founding to for the first few years where things are negative and they're growing, you get a negative ratio, it's kind of useless. So, don't worry about it too much, look for other ways to assess valuation.

Then, if you have a successful company from growth in that incubation period, you know, you get to a stage where the company is growing quickly. So, think Starbucks in the '90s, for example. I think Howard Schultz took over in the late '70s, and you know, maybe incubates the company into the mid '80s. So, mid '80s to mid '90s, Starbucks rapid growth. Earnings are small, price is high, so you're going to get a high price-to-earnings ratio, but that's not necessarily a bad thing, because growth forgives a lot of sins. Growth, you can grow out of your -- I remember someone close to me sold their Starbucks shares at 80X earnings, a of 80. If she had held it, she sold a 20-bagger from there. So, she would have 20X more money today than when she sold it. But she looked at the ratio, which was 80, said, oh my goodness, that's too high, and she bailed early.

You get to the mature, kind of, adult stage of a company's life, so you know, maybe like Starbucks today, frankly, growth has slowed down, or Home Depot is another great company very much in its mature phase, but dominant, the ratio is useful; you want to see some steady growth there. And so, at this point we'd say, well, if the ratio for Home Depot, say, is 15% or 20% lower than it was six months ago, maybe it's a good deal today, but that's what you're going to use ratio for is to assess relative valuation. And then finally, if you get over to the hump, as you go into the decline of a company's lifecycle, you know, the ratio might look really cheap. I would point you to a good number of oil and gas exploration companies today where it looks really cheap and the words you want to use are "value trap," you want to stay away from those, even if it looks cheap or even a company that's more of a cyclical company in nature, when they look their cheapest, they're actually the most dangerous, because it's the market pricing in the absolute top of the market cycle.

So, again, in the birthing stages of a company, ratio is often negative, arguably useless. High growth stages, you can calculate it, but it's going to be high and it might scare you off, maybe it shouldn't, so it's semi-useless. In the mature phase, it's very useful. In the declining phase it's kind of useless, so. And I'm going to shout-out our Foolish colleague Brian Feroldi, Chris, who put together a very -- if folks want to look for him on Twitter, just like, " ratio" and "Brian Feroldi," you'll find he's put together a really nice pictograph of this very thing I've just described.

Hill: Question from Brian McCullough in Calgary, who writes, "I've been listening since 2012 and I'm a member of The Motley Fool Stock Advisor service. Thank you for the great recommendations." You're welcome. I say that like I have any involvement in Stock -- like, I'm the one -- [laughs]

Gillies: Well, I will say, Chris, I do contribute to Stock Advisor Canada. So, we'll assume here that Brian, because he is from Calgary, my favorite Canadian city, mainly because it's an hour out of the mountains, we'll assume he owns Stock Advisor Canada there. [laughs] So, I'll take a tiny piece of credit.

Hill: [laughs] Brian continues. "I've seen the ETF Invesco Solar, the ticker symbol is TAN, I've seen this ETF increase significantly this year. It follows stocks such as SolarEdge Technologies, Enphase Energy, and Sunrun Incorporated. I'm wondering if these stocks are a good buy, and if they're still a good buy at these prices given their recent increase."

I will just point out, just to timestamp this, this ETF, Invesco Solar, hitting a multiyear high today.

Gillies: Yes. Do you want the short answer or the long answer? Well, that is a friend from Calgary, so fellow Canadian, I'm going to go long.

Hill: How about the medium answer?

Gillies: Oh, OK. I love this question. I'm a big proponent of solar. I have solar on my house, which helps to power my mostly electric car. I'm a big fan here. I wouldn't go near this ETF with your money, Chris. So, here is the problem. First off, this is almost a textbook example of investing in the rearview mirror or using the rearview mirror to govern our investing. And I'm going to, since we've already talked before, we recorded about a little bit of history and Black Friday, I'm going to give you another little piece of history.

In 2000, so 1999 was like the apex of the great tech bubble. The Nasdaq index was I believe up 80% that year. And so, now you're in 2000, and I'm going to get a Canadian cut here. In Canada, our retirement accounts, RRSPs, tend to get a big marketing push to fund your RRSP around February. So, the first two months of the year. Would you like to hazard a guess, what industry was the single greatest, and it's not close, the single greatest beneficiary of new money flowing into the market in February of 2000? And if you said tech, goldstar. Most of the money that came in that year went into tech funds, because they had done so well the year before and the two years before. This is easy money, right? Then, of course, the bubble popped in March of 2000, touched off a grinding down market from March 2000 to October 2002. That killed the Nasdaq, I believe, over 65%, 70% over that time; I could be wrong.

So, the point is, the people who are going into tech funds at that time were investing in the rearview. So, this ETF, you said hitting multi-year highs today, Chris. The one-year performance for this fund is about 120%, which, you know, not by coincidence, is roughly the one-year performance of the index that purports to track the MAC Global Solar Energy Index. Up about 120%. But dial out, don't look at one year, look at five years. Five years the performance is annualized roughly 20%. Now, five years, 20% is still pretty good, but realize you're getting this last year, which is up 120%, is influencing those five years. So, it probably had a bunch of flat to negative numbers in the first four and then you tack 120% on and you annualize that and you get 20%.

Dial back out even further, Chris, the 10-year performance for, both, the index and this ETF is negative. So, to put in perspective, 10 years ago, Chris, you and I. You go put $10,000 into the market, you today, you have about $24,500. I go 10 years ago and I put $10,000 into this ETF, I have roughly $10,000. So, this has not been long-term money -- the performance in the last year is solely because people have, kind of, gone a little crazy chasing these solar companies. Now, again, I mentioned, I have solar installed on my house. And I will tell you the single biggest risk factor you should be worried about when you put solar on your house or you look at solar as an investment is that you are highly dependent on the subsidy programs within the jurisdictions where these companies sell their products, because frankly, solar is a commodity, there's nothing special about my panels versus yours, there's nothing special about my inverters versus yours or my racking systems or whatever.

In my town, I get a little bit of a benefit because we have what's called net metering, so I put some of my generated energy back into the grid, I get some credit for that. It's not great, but, you know, it is what it is and I put it on my house, because of my background, I have environmental engineering, a couple of degrees in that thing. I spent a decade in practice. This is kind of what I like. So, you know, I'm like, ah! I took the opportunity, we put it in the house. I can tell you, friends of mine, before the government changed the rules to go to net metering, friends of mine put solar on their house, they're getting a nice fat check every month, because their system is grandfathered. It was so generous that the people who put solar in at that point in time got these generous payoffs. The government said, hey, we want to stop giving generous payoffs, and so they changed the rules to go to net metering. I don't get a check every month; that's fine, it's OK, but I could tell you, and speaking to the installer for the system, one they put on my house just over a year ago, I asked him, how's business? And he basically said, when the government changed the rules, the number of installs we did dropped by almost 90%.

So, if that happens in any of the jurisdictions where these companies -- he mentioned SolarEdge, Enphase, Sunrun, these are all really expensive companies in terms of their valuation. I think I looked at SolarEdge, it's trading at almost 70X free cash flow. You had best hope that wherever they are selling their products, they don't change the rules, because if you do, that stock is going to get a lot cheaper a lot faster.

Hill: Earnings season kicks into high gear this week. I want to get to your earnings preview in a second, but since Brian McCullough brought up Stock Advisor, for those interested in our Stock Advisor service, you can go to Listeners of this podcast get 50% off. Speaking of things getting a lot cheaper very quickly: If you're not yet a member of Stock Advisor and want to kick the tires on it; what are you watching this earnings season? Keeping in mind that we'll have a Presidential election here in the United States ... [laughs]

Gillies: Are you really?

Hill: Yeah, you might have heard something about that. We're going into, you know, the most crucial season for retailers. But what is, it can be a company, it can be an industry, it can be an executive, what are you watching?

Gillies: Well, I am like a kid in a candy store for the upcoming earnings reports, Chris. Because I like -- and it's kind of sad, frankly. And it shouldn't be popular and frankly I should probably seek help. I like looking at stories that don't fit into easy headlines. I like pulling apart earnings reports to find hidden value, if you will, or to find things -- like, you know, we mentioned earlier, remove one-time charges and adjust numbers. I happen to think that's the cornerstone of my personal investing edge and my personal investing style, looking for, you know, things that aren't what the headlines make them seem.

And we're coming out of a pandemic, or we are still in a pandemic, I suppose, but we're coming through, we're seeing how the pandemic is impacting earnings reports, impacting company financials. And my goodness, all you have, every company, every report, you have to adjust and interpret, and it's just, again, it's -- I'm not fun at parties, but this is kind of what I like to do. So, what I think is interesting is whether the story is the broad pandemic recovery or not. I mean, we are seeing some things manifest in quarterly earnings reports. We've already gotten a few previews, because whether companies are off a calendar year cycle. So, we talked a couple of weeks ago about Levi Strauss, for example, the jeans maker. They had a much better quarter than expected, the stock reacted accordingly. We've seen the big banks in the U.S., which are in the same calendar cycle, but they have reported, most of them, and the thing that comes across from those, is that they have all pretty much pulled back on loan loss reserves. I mean, they all pretty much easily surpassed expectations, because they pulled their loan loss reserves in. Now, are they gaming the system?

We also talked previously, I believe, Jamie Dimon, he's CEO of JPMorgan as you know, he said, well, we think we've done the right thing. We think we've reserved accordingly, but as things go south again, maybe we'll have to put another $20 billion in. But if things are good, maybe we take $10 billion out. So, there's all kinds of things moving. There's a Canadian restaurant franchising group that I follow called MTY Food Group, they had a much better quarter than a lot of people were expecting, the stock reacted very well, mainly because their two biggest concepts are pizza, what's more deliverable in a pandemic than pizza, and ice cream, well, you know, the world shut down, but hey, you can still go out for ice cream. So, it's how those stories -- we've got a smattering of them. And like I mentioned in these one-off reports, we're about to get the firehose where everybody reports how they've done. And I'm really intrigued to see a number of restaurant companies, a number of just general service providers, retailers, of course, are going to be interesting, to me, and also REITs; how are the REITs doing if they are renting property, say, to retailers, movie theatres, that sort of thing? So, it's basically the general theme, pandemic healing or not, as the case might be.

Hill: A lot to pour over, that's why it's my favorite season of the year, and I love that it comes four times a year. Before we wrap up, quick shout-out to my sister, today is her birthday, and she'll be listening to this tomorrow, because that's how she consumes. So, Sis, I love you; Happy Birthday yesterday!

Jim Gillies, always good talking to you, thanks for being here.

Gillies: Thank you.

Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear.

That's going to do it for this edition of MarketFoolery. The show is mixed by Dan Boyd, I'm Chris Hill, thanks for listening, we'll see you tomorrow.

Chris Hill owns shares of Starbucks. Jim Gillies owns shares of Starbucks. The Motley Fool owns shares of and recommends Home Depot, Starbucks, and Twitter. The Motley Fool recommends SolarEdge Technologies and recommends the following options: short November 2020 $85 calls on Starbucks. The Motley Fool has a disclosure policy.

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