In life, people prefer the simple to the complex. However, when something that is inherently complex is misunderstood and thought of as being simple, it can cause problems. That’s the way that HFS feels about the Price-to-Earnings (P/E) ratio. We believe this popular valuation metric is one of the most misused and misunderstood in the investment industry. Too often, people (many who should know better) think that equity investing is just buying lower P/E ratios and selling higher ones. If it were that simple, many of us in the investment industry would be unemployed because any person with an internet connection could outperform. Spotting high or low P/Es is not an investment strategy.
The P/E ratio is a powerful tool. However, what many fail to understand is that it is shorthand for a complex valuation equation called a discounted cash flow (DCF) model. This states that a stock’s price represents the present value of its estimated future cash flows. A P/E ratio is based on the same principle. Without getting into the details, we think it’s helpful for people to understand the assumptions behind the P/E ratio to become more informed and make better decisions.
Let’s break down the following statement with some additional context:
A company’s price represents the present value of a company’s (1) estimated (2) future (3) cash flows.
- “Estimated” is a key term. Investors are using all available information about a company, its market, and competitive landscape to determine the probabilities of various outcomes. The more certain a scenario is, the more that outcome is reflected in the stock’s price, either positively or negatively. Companies with more uncertain futures tend to be more volatile and vice versa. However, all equity prices are based upon educated guesses. Instead of saying a stock is “cheap” or “expensive”, which falsely implies that someone knows the future, it’s helpful to instead think of a stock having “low expectations” and “high expectations”, both of which can be missed or exceeded.
- “Future” does not just mean this quarter, this year, or next. It means forever. Whether they realize it or not, investors are essentially trying to determine how big a business can become and how long it will be around. This is also why unprofitable companies can carry high valuations – investors anticipate that these firms will eventually generate strong profits. It’s also why a highly profitable firm can carry a low valuation – investors fear that its earnings trajectory is maturing and may begin declining. Keep in mind that the results from one quarter is a glimpse of time.
- “Cash flows” are not earnings. Instead, cash flows are the amount after a firm has made its capital expenditures (capex), or the costs of its property, plant, and equipment. All else equal, a firm that requires high capex will have a smaller P/E ratio to reflect its lower cash flows. The “E” in the P/E ratio is just used as an approximation of a firm’s cash flows.
Perhaps we got a bit wonky this week, but our point is simple – the P/E ratio is just shorthand for a very complex set of assumptions that extend deep into the future. The question isn’t whether the ratio is high or low, but whether a firm’s future fundamentals will exceed or fall short of investor’s long-term assumptions.
The opinions expressed are those of Harrison Financial Services as of May 23, 2024 and are subject to change. There is no guarantee that any forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Please remember that all investments carry some level of risk, including the potential loss of principal invested.