Why PE Ratios Don’t Matter

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Price to earnings ratios, or price-earnings multiples are some of the most ubiquitous valuation metrics available. Even non-investors have likely seen PE ratios appear on screen as they zoom by CNBC as they navigate through their TV channels.

A price to earnings ratio is a very simple valuation metric; it’s the price of a stock divided by the earnings of the company per share of stock. A company that has a per-share price of $15 and reports $1.50 of earnings would have a price to earnings ratio of 10. The company sells for a price 10 times its most recent earnings.

So why do I say that PE ratios don’t matter? Why would I think investors might put too much emphasis on PE ratios?

The Case for Killing the PE

Here’s why I think PE ratios are more likely to mislead investors than put them on the trail toward the next hot stock:

  1. Accounting trickery – Earnings can be inflated any which way you so desire. One way that companies can show positive earnings is to change the underlying dynamics in their pension programs. That makes for a great earnings quarter, but it does not change the mechanics of the business. Earnings go up on a nominal basis, but the true value of a business is left unchanged.
  2. Inaccurate Smoothing – Earnings often represent an inaccurate picture as cash flow to a business may not appear at the same time the company records positive earnings. For example, a company that earns $100 million per year every year for 5 years is very different from a company that has free cash flow of $0 for 3 years before 2 years of $250 million cash flows. If the company needs cash to pay down debt, or to expand, positive earnings do little to help the company’s business. However, positive free cash – cash which is free for further investment or debt repayment – can expedite the realization of the business’ goals. Take this as far as you need to. Let’s say you’re a new college graduate who can expect to earn $4 million over your lifetime. Would you rather receive $4 million cash at graduation, or $4 million in year 40 of your career? Any logical person sees that cash in hand is worth more than cash in the future.
  3. A Single Year Look – Price to earnings multiples shown on popular finance sites are for the most recent year. A woman on StockTwits tweeted that she was irritated that automaker Ford could not seem to find traction and move higher, even though it had a crazy low PE ratio of 2.2. Alas, Ford’s price to earnings multiple is calculated based on last year’s earnings. Last year, Ford accounted for a large, one-time earnings adjustment due to tax liabilities. Ford recorded an amazing accounting profit last year, but it hardly affects the business going forward. One cannot expect that because Ford “earned” nearly $20 billion last year because of tax accounting that the company will do it next year.

Warren Buffett on Accounting Earnings

Buffett – and most value investors, for that matter – are usually the most outspoken critics of accounting earnings. Buffett says he likes businesses that generate earnings in the form of cash. It’s one thing for an investor to invest in a business where “earnings” are just left in the form of more inventories, or more factories. It is another thing all together to report earnings and actually have the earnings available to owners in an asset that does not affect the business’ operations.

Think about it this way: you can’t take a factory out of a business to pay yourself. You could, but you’d severely cripple the business in doing so. You can remove free cash from a business without affecting a manufacturing business. Unless earnings result in free cash, though, there’s nothing to distribute.

Turning Earnings into Cash

A great example of a business that turns earnings into cash is Mastercard. The company provides credit and debit card processing services. This is not a very capital intensive business – you don’t need to buy factories, or invest in capital to process credit cards.

The company turned 85%, 84%, and 132% of its earnings into cash each year in the period from 2009-2011. Compare these figures to a company like CSX, a railroad operator. CSX turned 53%, 91%, and 66% of its earnings into cash in the same period. Building and maintaining railroads obviously requires far more money than does building out a credit card processing business. Where Mastercard has people, CSX has billions of dollars in railroads and infrastructure. Paying a salary to operate is much better than deploying cash in major investments that have a 20, 30 or even 50-year timetable.

True Wealth Creation

It’s really all about true wealth creation. While we could all mindlessly compound our assets over the long haul, at what point do we get to realize the benefits of a high net worth? Who cares if you own a billion dollar manufacturing business if all your cash flow is being reinvested into retooling your factory every few years just to stay in business?

Who cares if your cash washing business “earns” you better technology in your car washing business each year? You can’t turn sponges and wax into food without affecting your ability to do business.

And this is why it’s so important to disregard PE ratios and earnings on single stocks. A better ratio would be the owners’ earnings ratio – or free cash flow yield. An owners’ earnings calculation allows investors to see which companies are making an economic profit – a profit which can be distributed back to shareholders. While owning more of a business is excellent, owning more of a business that actually turns earnings into cash is a much better alternative.

Ignore PE ratios, and really just ignore earnings all together. Consider earnings only when it is possible for companies to turn those earnings into cash. And as a rule, look for the firms that end up with the most cash relative to their reported earnings. Morningstar has a “key ratios” page for any public company, which allows you to see at a glance how much of a company’s earnings actually ends up in cash.

Jordan Wathen

Value investor and writer. There's nothing I love more than digging into new investments that provide an excellent return with the greatest margin of safety. I am a big believer that the active investor can outperform the index in the long haul.

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One Comment

  1. I disagree, you have to find the balance between earnings and capital appreciation. I do this by investing in total market funds. I don’t want some company that’s going to pay out all it’s earnings every year, then there is no room for capital appreciation. On the other hand, I don’t want some company that’s going to keep building and building without ever turning a profit like you mentioned.

    How do you find that balanced company? I don’t think I’m qualified to pick so I’ll take a nice broad swath of all companies 🙂

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