The Price to Earnings Ratio and Stock Value

Chart Showing High P/E Ratio on a Stock
••• Hiroshi Watanabe/Taxi Japan/Getty Images

A mistake many investors make is associating value investing with only buying stocks with a low price-to-earnings (P/E) ratio. While a high P/E ratio has generated above-average returns over long periods in the past, it is not always the ideal method to use for valuation.

Intrinsic value is the calculated value of an investment, while also having a perceived value. Commonly, the calculated intrinsic value is the value used for valuation. However, the individual investor must perceive the value of the investment, as well—thus, intrinsic value is calculated and then perceived as valuable.

Key Takeaways

  • The definition of the intrinsic value of an asset is simple: It is all the cash flow that will be generated by that asset, discounted back to present value.
  • Investors must distinguish between the reported net income and true, "owner" earnings—the amount of cash that the owner could take out of the business.
  • Return on equity is another important measure that indicates the profit earned after taxes to the total amount of shareholder equity.

Intrinsic Value Gives a Business Different Valuations

At its core, the basic definition of the intrinsic value of an asset is simple: It is all of the cash flows that will be generated by that asset, discounted back to present value. It is also at an appropriate rate that factors in opportunity cost (typically measured against the risk-free U.S. Treasury) and inflation.

Applying Intrinsic Value

Figuring out how to apply present value to individual stocks can be difficult depending upon the nature and economics of the particular business.

Benjamin Graham, the father of the security analysis industry, believed you had a much higher likelihood of experiencing satisfactory investing results over long periods, by focusing only on those opportunities within your circle of competence, that you know to be better than average.

All businesses are not created equal. An advertising firm that requires nothing more than pencils and desks could have more intrinsic value than a steel mill that requires tens of millions of dollars in startup capital investment.

All else being equal, an advertising firm deserves a higher price-to-earnings multiple. This is because the shareholders aren’t going to have to keep shelling out cash for capital expenditures to maintain the property, plant, and equipment in an inflationary environment.

Net Income and Profit to Earnings

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 or spend.

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—or, return on investment (ROI).

Return on investment (ROI) is the measure of what you receive for the capital you give.

Capital-Intensive Companies

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 (ROE) generated by the underlying company.

Return on equity is another important measure for investors. It is a measurement that indicates the profit earned after taxes to the total amount of shareholder equity. This profit to equity metric demonstrates how different variables (revenue, taxes, interest, asset turnover, etc.) contribute to the returns on equity.  When using return on equity as a measure to value a stock, you should also be mindful of the amount of debt carried by the company. This leverage would inflate the figure reported in the ROE metric.

The result of this fundamental view is that two businesses might have identical earnings of $10 million. Company ABC might 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.

It is important to remember that financial ratios should not be considered separately as indicators of performance. Rather, they should be used in conjunction with each other, for a more holistic view of performance.

Stocks With a High P/E Ratio and the Margin of Safety

The danger with this approach is that if it is taken too far, any basis for rational valuation is quickly thrown out the window. Typically, if you are paying more than 15 times the earnings for a company in an ordinary interest-rate environment (20 times per earnings in a sustained record-breaking low-interest-rate environment), you need to seriously examine the underlying assumptions you have for its future profitability 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 50 times the 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% 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 of P/E Ratios

For an investor, the perfect situation arises when you get a 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. Businesses in some sectors are now in the position that a video rental franchise was then—technology is changing the way that businesses and consumers interact, causing uncertainty in some industries.