Here's a question for you. Which company is valued more reasonably: Pfizer (NYSE:PFE), with a price-to-earnings (P/E) ratio of 23, or Bristol-Myers Squibb (NYSE:BMY), with a P/E ratio of 16? The latter would appear to be the obvious choice. It even carries the higher dividend yield. We'll get to the answer in a bit -- but first, let's talk about the P/E ratio.
Long ago, I gave up on the P/E ratio as a tool for valuation. I'm not the only one -- Motley Fool Inside Value advisor Philip Durell has also written at length about the P/E ratio's limitations. I'd like to further explain why I'm paying very little attention to the P/E ratio, P/FCF (free cash flow) ratio, P/S (sales), P/EBITDA (earnings before interest, taxes, depreciation, and amortization), or any other price-based ratio you can think up.
It's not that useful
The "E" in the P/E ratio is based on earnings as defined by Generally Accepted Accounting Principles (GAAP). I don't think GAAP is bad or faulty, but in its attempt to match revenues and expenses, GAAP leaves the door open for management to make estimates. This isn't a bad thing for conservative management, but in the wrong hands, net income and earnings per share can be manipulated. This means that net income often won't reflect the actual cash a company had available to it at the end of the year to fund dividends and other activities.
For this reason, free cash flow -- with company-specific adjustments for items like acquisitions -- is a much better way to go. Price-to-free cash flow is also more useful to investors than the P/E, because it gets closer to actual cash earnings, but even P/FCF is flawed from a valuation perspective. It only tells us about the performance over the previous 12 months. It's not taking future growth into account, and most importantly, P/FCF doesn't include what it costs a company to generate the growth.
There's better way to determine value
It makes a lot more sense to value companies using a discounted cash flow (DCF) analysis. It's the only method that takes into account future growth and the cost of that growth. My Foolish colleague David Meier wrote a piece that ran through the mechanics of a DCF analysis, and I recommend giving it a read.
This brings us back to our two big pharmas and their respective P/E ratios. Looking at them straight up, Bristol-Myers Squibb appears to be the lower-priced or more undervalued company. But digging a little deeper into free cash flow -- and running both companies' numbers through a basic discounted cash flow analysis -- shows that Pfizer has growth of 0% priced in for the next five years and 3% thereafter, whereas Bristol-Myers Squibb has 4.5% growth priced in for the next five years and thereafter. Regarding how quickly each company must grow to justify its current valuation, Pfizer is actually the better deal.
If it were all that simple, we could move on and determine that Pfizer is the better deal. But the question remains: Could Pfizer grow less than what is priced into its shares? Could Bristol-Myers grow more? That's a question for another day, however; the point is that the P/E ratio doesn't take into account future growth, and therefore, it's not always the best way to tell which of two companies is really less expensive or undervalued.
Performing a DCF analysis is also quite portable. Instead of using big-pharma companies like Pfizer and Bristol-Myers, I could have performed a similar DCF analysis between retailers Target (NYSE:TGT) and Sears Holdings (NASDAQ:SHLD). When it comes to your own portfolio, it can even make sense to compare DCF valuations -- but not operating metrics such as inventory turns -- between companies in different industries, such as consumer electronics titan Matsushita Electric Industrial (NYSE:MC) and teen-apparel retailer Aeropostale (NYSE:ARO). Although Matsushita looks ridiculously expensive, with a P/E ratio of 75 compared to Aeropostale's more pedestrian P/E under 20, my comparative DCF analysis concludes that the valuations of these two firms are not nearly as far apart as their respective P/E ratios might indicate.
Wrapping it all up
There are a couple of uses left for the P/E ratio. In the piece I referenced above by Philip Durell, Philip mentions that he likes to look at a company's P/E ratio in a historical context to see whether a company is trading below its normal P/E. But don't be small-"f" fooled by Philip's intent here. He's using the P/E to determine whether he should dig deeper and perform a more detailed examination -- including a discounted cash flow analysis. The P/E ratio also works as a screening criterion, to help isolate companies that may be undervalued and thus merit deeper analysis. The important thing is that the P/E isn't being used to determine a valuation -- instead, it's helping you decide whether valuation might be worth doing.
For more on Foolish valuation:
Pfizer is a Motley Fool Inside Value recommendation. Looking for value? Motley Fool Inside Value analyst Philip Durellscours the markets for undervalued businesses that can be held for years. In a little more than a year, Philip's selections have outperformed the S&P 500 by an average of more than 4 percentage points. If you'd like to join the hunt for the market's hidden bargains, test-drive afree 30-day trialto Inside Value.
Nathan Parmelee has no financial interest in any of the companies mentioned. The Motley Fool has a disclosure policy .
