What High P/E Ratio Means to the Value of a Stock

High P/E Ratio Stocks
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A mistake investors tend to make is associating value investing with only buying low price-to-earnings ratio stocks. While this approach has generated above-average returns over long periods, it is not always the ideal.

Intrinsic Value and Why Different Businesses Deserve Different Valuations

At its core, the basic definition of 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. But by focusing only on those opportunities clearly in your circle of competence that you know to be better than average, Benjamin Graham, father of the security analysis industry, believed you had a much higher likelihood of experiencing satisfactory, if not more-than-satisfactory, results over long periods.

All businesses are not created equal. An advertising firm that requires nothing more than pencils and desks is most likely 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 deserves a higher price-to-earnings multiple because in an inflationary environment, the 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 owners can buy relative to their 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 view 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.

Stocks With a High P/E Ratio: The Importance of a Margin of Safety

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. In the 1990s, the cheapest stock in retrospect was a major computer manufacturer at 50x earnings. When it came down to it, the profits it generated meant that, had you bought it at a price equal to a mere 2 percent 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 personal computer, and the low-cost structure that gave the business an advantage over its competitors? 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.

A test you can use is to try to imagine what a business will look like in 10 years. Both as an equity analyst and as a consumer, do you think the business will be bigger and more profitable? How will profits be generated? What are the threats to its competitive landscape? If you had been asking these questions around 1990, you might not invest in a company whose profits depend upon manufacturing typewriter ribbons. If you had been pondering these questions around the year 2005, you might wonder about the efficacy of a large video rental franchise, as other technologies began to render that business obsolete.

Are businesses in certain sectors now in the position that a video rental franchise was then?