Forget the P/E

It has every available quality except that of being useful.
CS Lewis

A company with a low price/earnings multiple can be considered a better value stock than a company with a high price/earnings multiple.
Conventional Wisdom

If you are an investor in the sharemarket, you have probably read the above statement in numerous articles written by well-intentioned journalists, in countless books by equally well-intentioned authors and in research published by professional analysts.

The statement is, however, misguided and misleading and those who make it may be displaying their ignorance rather than their insight.

In my first job as an analyst, fresh out of university, I also thought I was showing off my knowledge when I could recite the price/earnings (P/E) multiples of the companies I had “analysed”, those in whose shares I had invested, the aggregate P/E ratio of the broader market or the relative P/E ratios of companies within a sector or of overseas peers.

My initial acceptance of the P/E is easy to understand. My mentors, my supervisor and every newspaper article written about listed companies supported my use of the P/E ratio and indeed condoned it. The humble P/E multiple was thus elevated from a rule-of-thumb to a specialist tool for analysts.

Today, managing a more significant amount of money '” for clients, shareholders, friends and family '” I see the P/E as a rudimentary and clumsy guide for investors. More tellingly, I could not immediately tell you the P/E of any of the companies whose shares we own (sure, I could work it out quickly enough, but I don’t know off-hand).

Yet, as my interest in P/Es has declined, the readiness of commentators and stockbrokers to quote the P/E in all its forms remains unyielding and, more worryingly, unquestioning.

The P/E or price-to-earnings multiple, is simply the market price of a company’s share divided by the company’s earnings per share.

It is widely regarded as a measure of value, a way to determine whether a company’s shares are cheap '” as the following from the Australian Stock Exchange’s own website confirms: “In particular, value investors have long considered the price/earnings ratio (p/e ratio for short) a useful measure of the relative attractiveness of a company's stock price.”

But despite its popularity, sharemarket investors should question any blind faith they have in the P/E multiple. Why? First, some of the world’s most successful investors say it is irrelevant; and second, we can use some basic arithmetic to demonstrate there is little use for it.

Berkshire Hathaway chairman Warren Buffett, possibly the world’s most successful investor, once said: “Irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value, the investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one the investor should purchase.”

It is the section, “irrespective of whether the business carries a high price or low in relation to its current earnings” that is relevant to this discussion. Buffett is declaring that P/Es are virtually irrelevant in determining a great value-investing opportunity.

Think about this: Price is what you pay and value is what you get. Your job as an investor (as opposed to speculator) is to buy assets for less than what they are worth. If Benjamin Graham (Buffett's mentor), was correct when he said, “in the short run the market is a voting machine, but in the long run it is a weighing machine” then, by acquiring businesses at below their long-term worth, the market will eventually recognise and reflect that worth.

We have seen this occur in Australia far too many times to disagree with Ben Graham and so have become avid proponents of the rational approach to value investing.

But the P/E has nothing to do with true value investing. It merely compares price to earnings, and price is not value.

As value investors, we are interested in the comparison between price and value, and only then can we identify whether a company’s shares are bargains or not.

There are two basic problems with P/E multiples:

• The P/E figure is irrelevant in determining return to an investor.
• Earnings per share and earnings growth are unimportant in determining both attractiveness and value.

Any chef knows that if you add chocolate chips, you don’t get a lemon meringue. It’s the same with valuation formulas. If price is an input, you don’t get value as an output. Conceptually that is easy to understand. A couple of tables should help cement it.

Table 1 is a company that generates a normalised rate of return on equity of 5% '” a mediocre retailer, for example, and retains all its earnings, paying no dividends.

Assuming the shares are purchased and sold at the same P/E, the internal rate of return (IRR) to the shareholder will be equal to the company’s rate of return on equity, in this case 5%. Given this rate of return on equity is lower than can be obtained elsewhere, it appears rational that the company should not retain its earnings but pay them out. The P/E multiple of 10, however, is silent on these issues.

In Table 2, the company also has $1 of equity, generates a 5% return on equity, but management is rational in the face of inferior returns on equity and pays all its earnings out as a dividend. As a result there is no growth in the earnings. Regardless of the fact that the company has no growth in earnings, the shareholder now achieves a higher return (an IRR of 10%), buying and then selling five years later at the same P/E.

Comparing the rates of return from the two tables, it is evident that for every dollar the company retains, 50¢ of shareholders’ wealth will be destroyed.

You will notice that the investor’s rate of return, as expressed by the IRR, is higher when a company with a low return on equity pays all its earnings out as a dividend. This is rational behaviour on the part of management who “think like owners”. They wouldn’t invest their bonus payments and other incentives at 5%, given the risk of running a business, so they shouldn’t invest the funds of the owners/shareholders at the same rate.

Uninhibited earnings should only be retained when there is a good possibility (use history as a guide) that capital retained will produce incremental earnings at a rate that is equal to or higher than returns produced by alternative investment options.

The above tables assist in the understanding of the misguided trust placed in the P/E as a measure of “value”. Both companies had a P/E ratio of 10, both generated a return on $1 of equity of 5%, so in the first year both could be purchased at the same price. But the company in the second table produced a return to investors that was double that from the company in the first table. So what use is the P/E of 10, or of 12 or 13 or any other number for that matter?

Over the years, a never-ending stream of commentators has attempted to encapsulate a definition of “value investing”. Many refer to the P/E, suggesting that low prices compared to earnings are an indication of whether “good value” is being presented.

Fund manager Philip Pepe from Platypus Asset Management recently suggested: “'¦ market P/Es are reasonable. The prospective P/E for the S&P/ASX300 is around 13, which represents good value.”

Such conclusions are erroneous because absolute value cannot be determined this way. As we have just demonstrated, it’s not the P/E that determines whether a share investment represents good “value”, it is the rate of return on equity of the underlying business, the rate of distribution versus retention and the investor’s desired rate of return that will establish whether a share is overvalued or undervalued for that investor.

A rational alternative

Because price is what you pay and value is what you get, the only way to estimate a rational price is to adopt a valuation model where no input is derived from price '” not the P/E ratio, beta or the weighted average cost of capital.

For the value investor, the best thing to do is forget about the P/E multiple. It’s rudimentary, clumsy and, worst of all, over-rated.

Rather, it is the “business owner” approach to investing in the stockmarket that is precisely what Benjamin Graham and later, Warren Buffett, espoused and have been advocating for decades. It’s the only way to value a company. Beware of irrational, illogical and flawed imitations.

Roger Montgomery is the managing director of Clime Capital Limited.