Karl Siegling, portfolio manager at Cadence Capital, authored this piece for Morningstar Australia where it originally appeared. It has been edited for an Indian audience.
The reason for focussing on the price-to-earnings, or PE, ratio is because it is widely quoted by the broking, investment banking and investment community.
Simplistically, we divide the price of a share by the earnings per share, or EPS, or the market capitalisation of a company by the net profit after tax. For example, a Rs 200 share price divided by EPS of Rs 20 represents a PE ratio of 10.
Early on we are taught that, theoretically, this means that if we were to buy this company today it would take 10 years to earn back our investment.
Of course, with all theories the reality is quite different. Perhaps the most troubling part of this theory is that when you buy a share you have to pay with cash or a version of cash. The earnings that you receive in return for your cash ... are not necessarily cash.
The problems
1) The biggest and, by far, the most dangerous component of the PE ratio is that the earnings are the accounting earnings as defined by the accounting standards for a particular country. These earnings are not the cash earnings of the business.
In fact, many companies listed on the stock exchange earn no cash despite reporting profits.
2) A problem with the PE assumption is that future earnings will be at least what they are currently. In the case of a company trading on a 10 times PE ratio, we as investors are taking a chance that earnings will be at least what they are today for the next 10 years!
Working as an investor in the industry, it is quite clear that estimating the earnings of a company listed on the stock exchange for a year or two into the future is extremely difficult, let alone 10 years into the future.
3) Another problem with the PE ratio is the idea that 10 times earnings is cheaper than 15 times earnings. The assumption that a company will earn its current earnings for the next 10 years and an investor will get their money back is, of course, theoretical.
A company's earnings may well go up significantly or down significantly over the next 10 years. It would follow that we as investors should prefer to own a company whose earnings go up significantly over the next 10 years rather down significantly. The PE ratio has no way of telling us what will happen!
4) The PE ratio tells the investor nothing about a company's balance sheet. It may be that a company trading on a 2 times PE multiple is actually incredibly expensive since the company has a very large amount of current debt that it has no way of paying, and as a consequence, the company will be declared bankrupt in the current financial year.
We need only look back to the recent global financial crisis to find many examples of companies in exactly that situation.
5) The PE ratio tells us nothing about the quality of a company's earnings. We may look at one company trading on 8 times earnings and declare it cheaper than a company trading on 16 times earnings.
We often hear conversations along these lines. However, upon closer inspection we discover that the company trading on 8 times earnings has just had a one-off profit never to be repeated and that the company on 16 times earnings has displayed 20% per annum earnings growth for the past 15 years.
It may well be that once these factors are taken into account, the company on a 16 times PE multiple is actually a better investment than the company on 8 times.
The list of problems associated with the PE ratio goes on and on. However, these may be the top five problems associated with the PE ratio. Let’s promise ourselves that we will never look at the PE multiple again as a serious tool for fundamental analysis.
Also read 3 beginner mistakes in equity investing and How useful is fundamental analysis?
