"What is 'investing' if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value -- in the hope that it can soon be sold for a still-higher price -- should be labeled speculation." -- Warren Buffett, 1992 letter to shareholders of Berkshire Hathaway
In this short passage, famous investor Warren Buffett distinguishes investors from speculators by saying that investors have a method to calculate the value of a stock. "Investor" is a term I like to use for myself, and I hope you do too.
But calculating a stock's value is a complicated activity full of nuance. And as a younger investor, I wasn't aware of the complexities. I was only aware of one facet: the price-to-earnings (P/E) ratio.
In this article, we're going to look at the right and wrong ways to use the P/E ratio in guiding your investing decisions by using three stocks owned by Buffett's Berkshire Hathaway: luxury furniture store RH (RH 4.95%), computer and printer maker HP (HPQ 1.11%), and media company Paramount Global (PARA 3.14%).
Below-average valuations
I've chosen HP, RH, and Paramount because, from a P/E perspective, these stocks trade at below-average prices. According to YCharts, the average P/E valuation for companies in the S&P 500 is about 19. By comparison, HP, RH, and Paramount trade at P/E valuations of 9, 11, and 4 respectively.
S&P 500 P/E Ratio data by YCharts
There are two parts to this valuation metric: The stock price, and the earnings of the company. If the price goes up and the earnings stay the same, then the valuation gets more expensive. But if the price stays the same while the earnings go up, then the valuation gets cheaper. The reverse of these statements is also true.
HP, RH, and Paramount are all profitable and look cheaply priced compared to the market average. Does that mean they're all undervalued and that investors should buy right now? Not necessarily.
As you may have already realized, the P/E ratio is calculated with past earnings. But if future earnings decrease, then perhaps these three stocks aren't so cheap after all. You'll misuse this helpful metric if you simply look for the lowest valuation number without also adequately assessing a business's future prospects.
As famous investor and Buffett disciple Bill Miller once wrote: "I often remind our analysts, 100% of the information you have about a company represents the past, and 100% of the value depends on the future."
Looking to the future for value
Indeed, earnings will likely drop for HP, RH, and Paramount in 2023.
The fastest-growing part of Paramount's business is its direct-to-consumer segment, which includes streaming service Paramount+. However, this segment is its most unprofitable by far, and it's a large part of why analysts predict the company's earnings will fall in coming years.
HP earned $3.05 per share in its fiscal 2022. But because of a slowdown in consumer demand and some restructuring of its business, management only expects to earn between $2.22 per share and $2.62 per share in fiscal 2023.
Shareholder returns can be good for businesses like this over the long term if they can maintain share repurchases and dividend payments. But in Paramount's and HP's cases, they're already pushing the upper limits of what they can return to shareholders.
HP returned 138% of its free cash flow (FCF) to shareholders in fiscal 2022 -- more than what it made. For Paramount's part, through the first three quarters of 2022, it paid $471 million in dividends while only generating $326 million in net cash from operating activities.
RH is the best of these three stocks to buy right now, in my opinion, even though it has the highest P/E ratio. To be clear, its earnings should also come down in 2023. Management has explicitly stated that it expects sales to fall in the near term, and that the brand will lose market share because it's not cutting prices like competitors.
RH doesn't pay a dividend. And while it's authorized to repurchase roughly one-third of its shares, management hasn't done so because it's preserving cash.
However, these are actually prudent long-term moves. If RH cut prices now, its customers would expect the same in the future. This would hurt its profit margins down the road, when they've historically been the best in the furniture space.
Moreover, RH is expanding its business beyond furniture to hospitality, travel, and design, and also expanding internationally to take its business to over $20 billion in annual revenue -- many times larger than today.
I believe RH has higher long-term upside than HP or Paramount. And it's making moves today to ensure it gets to where it wants to go. I believe that's the right choice. While the near term could get shaky, the stock is trading near its cheapest valuation ever. All of this adds up to make RH the value stock for me today.
