Does a High P/E Ratio Mean a Stock is Overvalued?
If you've read my writings covering investing, portfolio management and financial independence, you know I’m an unabashed, dyed-in-the-wool value investor with a preference for long-term, highly passive holding. Yet, a mistake many people tend to make is to associate this with only buying low price-to-earnings ratio stocks. While this approach has certainly generated above-average returns over long-periods of time -- one great source of information that looks at the empirical data on this topic is called What Has Worked in Investing and was published by the a firm called Tweedy, Browne -- it is not always the ideal way to behave.
Understanding Intrinsic Value and The Reasons Different Businesses Deserve Different Valuations
At its core, the basic definition for the intrinsic value of every asset in the world is simple: It is all of the cash flows that will be generated by that asset discounted back to the present moment at an appropriate rate that factors in opportunity cost (typically measured against the risk-free U.S. Treasury) and inflation. Figuring out how to apply that to individual stocks can be extremely difficult depending upon the nature and economics of the particular business. As Benjamin Graham, the father of the security analysis industry, entreated his disciples, however, one need not know the exact weight of a man to know that he is fat or the exact age of a woman to know she is old. By focusing only on those opportunities that are clearly and squarely in your circle of competence and you know to be better than average, Graham believed you had a much higher likelihood of experiencing satisfactory, if not more-than-satisfactory, results over long periods of time.
All businesses are not created equal. An advertising firm that requires nothing more than pencils and desks is inherently a better business than a steel mill that, just to begin operating, requires tens of millions of dollars or more in startup capital investment. All else being equal, an advertising firm rightfully deserves a higher price-to-earnings multiple because in an inflationary environment, the owners (shareholders) aren’t going to have to keep shelling out cash for capital expenditures to maintain the property, plant and equipment.
This is also why intelligent investors must distinguish between the reported net income figure and true, “economic” profit or “owner” earnings as Warren Buffett has called it. These figures represent the amount of cash that the owner could take out of the business and reinvest elsewhere, spend on necessities or luxuries or donate to charity.
In other words, it doesn’t matter what the reported net income is because reported net income can be fudged. Rather, what matters is how many hamburgers the owner can buy relative to his or her investment in the business. That is the reason capital-intensive enterprises are typically anathema to long-term investors, as they realize very little of their reported income will translate into tangible, liquid wealth because of an important basic truth: Over the long-term, the rise in an investor’s net worth is limited to the return on equity generated by the underlying company. Anything else, such as relying on a bull market or that the next person in line will pay more for the company than you (the appropriately dubbed “greater fool” theory) is inherently speculative.
The result of this fundamental viewpoint is that two businesses might have identical earnings of $10 million, yet Company ABC may generate only $5 million and the other, Company XYZ, $20 million in “owner earnings." Therefore, Company XYZ could have a price-to-earnings ratio four times higher than its competitor ABC yet still be trading at the same valuation.
The Importance of a Margin of Safety When Considering Stocks With a High P/E Ratio
The danger with this approach is that, if taken too far, as human psychology is apt to do, any basis for rational valuation is quickly thrown out the window. Typically, if you are paying more than 15x earnings for a company in an ordinary interest-rate environment (20x per earnings in a sustained record-breaking low-interest-rate environment), you need to seriously examine the underlying assumptions you have for its future profitable and intrinsic value. With that said, a wholesale rejection of shares over that price is not wise. A year ago, I remember reading a story detailing that in the 1990s, the cheapest stock in retrospect was Dell Computers at 50x earnings. It sounds crazy but when it came down to it, the profits generated by Dell meant that, had you bought it at a price equal to a mere 2% earnings yield, you would have utterly crushed nearly every other investment.
However, would you have been comfortable having your entire net worth invested in such a risky business if you didn’t understand the economics of the computer industry, the future drivers of demand, the commodity nature of the PC and the low-cost structure that gives Dell a superior advantage over competitors, and the distinct possibility that one fatal mistake could wipe out a huge portion of your net worth? Probably not.
The Ideal Compromise When Looking at P/E Ratios
For an investor, the perfect situation arises when you get an excellent business that generates copious amounts of cash with little or no capital investment, such as American Express during the Salad Oil scandal, Wells Fargo when it traded at 5x earnings during the real estate crash of the late 1980s and early 1990s or Starbucks during the Great Recession collapse of 2009.
A nice test you can use is to close your eyes and try to imagine what a business will look like in 10 years. Both as an equity analyst and as a consumer, do you think it will be bigger and more profitable? What about the profits – how will they be generated? What are the threats to the competitive landscape? When I first wrote this article more than a decade ago, I included a paragraph that said, "An example that might help: Do you think Blockbuster will still be the dominant video rental franchise? Personally, it is my belief that the model of delivering plastic disks is entirely antiquated and as broadband becomes faster and faster, the content will eventually be streamed, rented, or purchased directly from the studios without any need for a middle man at all, allowing the creators of content to keep the entire capital. That would certainly cause me to require a much larger margin of safety before buying into an enterprise that faces such a very real technological obsolesce problem." Blockbuster did, in fact, ultimately go bankrupt. What businesses do you believe are in the position, now, that Blockbuster was then?