Putting a price to earnings

We continue our value investing series by looking at one of the most popular valuation tools.

This article is the sixth in an introductory series on value investing that was first published in 2006 and went on to become the core of our book Value: The Intelligent Investor's Guide to finding hidden gems on the sharemarket.
See also: 1. The essence of value investing; 2. What price a margin of safety?; 3. How to value stocks; 4. Value investing, via Don Bradman. 5. The beauty of book value.

As we’ve noted previously, shares are worth the present value of the future cash they generate, whether retained by the business or paid out to shareholders in the form of dividends. Financial theory suggests that you should value companies by putting together a complex discounted cash flow valuation.

Due to a number of shortcomings with this approach, however, it’s often better to stick to a few simple valuation tools instead. We discussed one such tool, the price-to-book ratio, here.

Today we’re looking at the price-to-earnings ratio or PER, probably the most popular tool used to value companies. As with price-to-book value and other simple valuation tools, however, it’s essential to see the PER purely in the context of helping you reach an estimate of the present value of a company’s future cash flows.

What is profit?

In simple terms, a business makes a profit if its cash receipts exceed its cash expenses each year. It can then retain this profit and reinvest it in its business or distribute it to shareholders.

When we come to value a business, we can either think of the reinvested element of profit as cash that’s available to us today (and it just so happens that we reinvest it in the business), or we can think of it in terms of the extra cash we’ll make in future on account of having invested it. However, to think of it as both would be to have our cake and eat it.

In the mystical world of economic theory, it actually makes no difference which approach we take, because we assume that our capital will generate the same returns whether we reinvest it in the business or in some other venture.

Valuation short cut

This provides us with a very neat valuation short cut. Instead of discounting and adding together a series of varying cash flows, we can just think in terms of this year’s profit (or rather earnings if we take the profit after tax) repeating year after year. Happily, the value of the same amount repeating year after year conveniently simplifies down to that amount divided by the return we’re aiming to make.

Let’s say, for example, that you aim to make a return of 10% per year, and you have a company that makes a return also of 10% and has a policy of paying out half its earnings and retaining the other half as investment in its business.

This year it makes earnings of $10m, pays out $5m and reinvests $5m. Next year, it’ll make $10.5m (the same $10m plus 10% on the $5m reinvested) and pay out $5.25m. In year three, it’ll make $11.025m and pay out $5.513m. Cutting a long story short, you’ll have a series of cash flows starting at $5m and growing forever at 5% a year.

Going the long way around, you could discount each of these cash flows at 10% per year and tot them up. You can take it from us that they’d come to a grand total of $100m. But taking the short cut, you could simply divide this year’s earnings by your targeted return of 10%—getting the same $100m and having time left over to play Pokemon Go.

In fact, however much of its earnings the company pays out, and no matter what return we target, so long as we assume the company will make the same return on its capital as our targeted return, then its value will simplify down to this year’s earnings divided by our targeted return.

This is the basis for the price-to-earnings ratio (PER), except that instead of dividing our earnings by our targeted return, we multiply them by the reciprocal of that return (that is, one divided by it). It amounts to the same thing.

So if we’re targeting a return of 8% a year, then we’d pay a PER of 12.5 (1 divided by 8%). And if we’re targeting 12% a year, then we’d pay a PER of 8.33. Whatever level you choose, we’ll call this your ‘reference PER’.

Theory breaks down

But just as with the price-to-book ratio we discussed here, elegant theory breaks down in practice. Some companies persistently make better than average returns on the earnings they reinvest, while others make poor returns. And the returns of some companies vary so much across the business cycle that it’s all but impossible to get a decent fix on their ‘underlying’ earnings.

At the top end of the quality spectrum, there are companies with considerable scope to reinvest large portions of their earnings at high rates of return.

These companies may be fair value at significant premiums to your reference PER. To put it another way, if you could buy them at around your reference PER, then their superior rates of return might provide you with a margin of safety.

In the middle, you’ll have companies that either pay out all their earnings or that make returns on their reinvested earnings similar to your targeted return. These companies would be fair value at around your reference PER, but to get a margin of safety you’d need to pay less.

At the bottom of the pile you’ll find companies that hog their capital and make poor returns. The worst offenders will be overvalued even on very low PERs and can be traps for the unwary. In fact, the PER is not an ideal tool for valuing this type of company—it’s often better to look at the assets and consider whether there’s a chance of that capital being put to better use.

So whilst the PER is a useful tool, it shouldn’t be used in isolation. You also need to consider the quality of the business and the return it’s likely to make on reinvested earnings. 

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