Theory

These are our thoughts on certain topics

P/E ratio

P/E is an easy to use and commonly used measure of company value, it can be described as what you would pay in price for one in earnings.

To understand whether a company is ‘cheap’ or ‘expensive’ it can be compared to its direct peers, its industry average, its country average, and against itself over time.

P/E is a relative measure, a stock could appear ‘cheap’ relative to its peers, but if the overall market is overvalued this peer comparison will not expose that.

Earnings are dependent on accounting assumptions which change over time and across companies. This is not as true for free cash flow and dividends which are just cash and don’t need adjustments.

P/E does not take future earnings into consideration.

Recent earnings are influenced by inflation, the stage of the business cycle, the stage of the company’s growth and other factors.

Low P/E can show a lack of trust or confidence in a company’s future earnings, a high P/E could mean the market is overconfident about the company’s future earnings growth.

Low P/E does not always mean a stock is ‘cheap’. Earnings could be exceptionally high and ready for a fall, or the future growth of earnings could be in peril.

Academic research has shown that buying low P/E stocks over the long term has been an outperforming strategy, providing an investor about a 2% “Value Premium” over growth stocks.

Using only EPS does not take into consideration future investments (capital expenditures and investment in working capital) which will be required to maintain earnings growth.

Cyclical stocks can look ‘cheap’ on a P/E basis at the top of their earnings cycle.

Companies with very low earnings may appear very expensive just before earnings are about to turn around.

Companies with no or negative earnings are difficult to value using P/E.

P/E does not take into consideration the level of debt, whereas EV/EBITDA does.

Some investors calculate P/E from recurring profit, which is preferred, while others just use net profit without adjustment. These different methods should not be compared against each other.

Certain regions of the world can have a sustained lower or higher P/E than others.

Analysts often make the mistake of comparing today’s price to prior year’s EPS.

 

P/B ratio

Book value is a cumulative number so it is almost always positive.

After a company pays dividends it retains a portion of its earnings which adds to book value, but this addition to book value is usually small, therefore the book value of a company is usually much less volatile than it’s EPS use for PE.

Book value is based on the historic accounting value of assets, which could actually be understated. A company could have an old asset that is recorded in its books at zero, fully depreciated, yet that asset may still be working just fine (though it may require more maintenance than a newer asset). So in this case the assets of the company would be understating the real market value of the assets it owns.

Almost all countries use historic account, though some allow for revaluation to market value.

A company that has accurately adjusted its assets to market value should theoretically trade at one times price to book as all future value is already captured in the value of the assets of the business.

But since most companies value their assets using historical costs an investor usually pays more than book value, the excess paid over one times price to book value should be for the future value attributed to that company.

If a company is going out of business then there is almost no future value possible from its assets, so P/B could be more useful.

The value of intangible assets is usually written down to zero in the balance sheet (Check with SK and make sure that this matches what you have written in SlimWiki about how intangible are accounted for) so these can be understated.

Some sector, such as Information Technology (companies like Google) are “asset light” so the P/B can be 10, 15 or even 20x…which may start to make this ratio less meaningful.

Different accounting standards across countries can mean that companies are not as comparable.