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speedybure (< 20)

The P/E Ratio: Fallacies and Foolishness

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April 24, 2009 – Comments (9)

One of the most common valuation metrics is the P/E ratios, yet the widespread misintepretation can be very dangerous. Lets first discuss the components that compose this ratio followed by potential dangerous it may convey. 

 

The ratio is the current market price/eps of P/Feps. Since this is used for equity analysis, it is neccessary then to include cash, marketable securities and interest bearing debt. In other words price alone is insufficient and must be adjusted by taking the (current market value of equity - cash + debt), also known as enterprise value(divide this by shares outstanding to get the enterprise value per share). This is a much better alternative because it will adjust the numerator accordingly which will eliminate distortions.

For those who don't know what the intrinsic value of any asset is to be: remember "THE VALUE OF ANY ASSET IS THE PRESENT VALUE OF ALL THE FUTURE FREE CASH FLOWS PRODUCED THROUGHOUT ITS LIFETIME." Earnings or EPS is not a measure of profitability! Thats right people EPS does not measure profitability for a few reasons......This is done best by first giving examples.

1) Lets say for example a company earned 200m after tax, with 100m shares out. EPS therefore is $2. But say the company must reinvest 25 million every year to replenish inventories (increase in non-cash working capital) in addition to another 125 million for new machinery (plant,property,equipment). In this case the net income available to common shareholders is 200m - 25m - 125m = 50m. In otherwords in order to keep the company operating the EPS after reinvesting the neccessary capital is .50 cents. 

2) Even More Common is the excitement over growth companies i.e they will grow revenue and earnings 100% for the next 2 years. For fast growing companies, almost all or even more than current earnings need to be reinvested in order to grow the next year.

 Conclusion: The P/E ratio is very flawed but luckily there is a much more accurate variation: EV/FCF (enterprise value/ free cash flow)/shares out.

 * If the speedy company earned 200 million after tax, needs 25 million for an increase in non-cash working capital and 75 million in capital expenditures. Speedy has 25 million in cash and 225 million in debt. It is trading at 10/share with 100m shares oustading.

== EV= (20*100m)-25m+225m= 2200m 

== Free-cash flow =  200m -25m - 75m= 100

P/FCF = (2200/100)= 22

P/E= 2000/200= 10

I think people may think twice buying a stock if the P/E was 22 as opposed to 10.. 

 

This is a brief and simplified example as i left out the effect depreciation expense has, aquisiions, what change in non-cash working capital is, etc. But this is useful for the reasons I stated above. This can also be done using forward p/fcf if you can project growth and cap-ex.

 

 

 

 

9 Comments – Post Your Own

#1) On April 24, 2009 at 5:41 AM, DemonDoug (81.58) wrote:

not to mention the fact that projections of future earnings are way too high, and can be way way too high, see 1999 and october of 2007 for recent examples.

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#2) On April 24, 2009 at 7:02 AM, outoffocus (22.83) wrote:

And now with our 20/20 hindsight we can now see that alot of that 100% growth came with increased leverage. Fast forward to today and we're bailing out these idiots.  We also bailing out the corporations that overleveraged themselves (tongue in cheek).

But seriously, I've never looked at the P/E ratio as a measure of profitability. I use it as a gauge to whether or not the company is overvalued price-wise.  I also think that Market Cap is used too often as a measure of enterprise value when the two are completely separate (see GM). 

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#3) On April 24, 2009 at 10:48 AM, speedybure (< 20) wrote:

yeh, im just putting this up for those who do look at it because i know a lot do.

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#4) On April 24, 2009 at 1:10 PM, speedybure (< 20) wrote:

Additionally, this is just one metric, albeit an important one. Valuation should always begin with qualitative measures, then in my opinion altman Z is the best formula (combination of formuals) to determine financial strength of the company. Only after this analysis (which is the most difficult), is it neccessary to use at least 3 or valuation methods i.e earnings yield, return on capital, dcf model, h-model, p/fcf,etc

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#5) On April 24, 2009 at 4:05 PM, DonnerDiv (34.24) wrote:

Speedybure:

Your analysis is a mish-mash jumble of the operating statement (P&L), balance sheet and cash flow analysis.

I don't want to be critical, but let me cite two misunderstandings.  Yes, inventory has to be purchased to replenish product shipped out the door.  But the P&L for the previous period charged inventory used against the incoming revenue.  If the same amount were purchased as that shipped out the door, there is no net effect nor loss.

Second, yes, some PP&E has to be (possibly) purchased.  But the preceding periods revenue was docked by depreciation of the existing PP&E.  If the PP&E purchased were equal to the past period's depreciation charges, there is no effect nor loss.

Where the heck did you study accounting?  Clearly quantitative fundamental of an equity requires analysis of the P&L, balance sheet and cash flow.  P/E ratio is simply one measure, insufficient on its own.

But to drag items across the P&L, balance sheet and cash flow report and mash them together is nonsensical.

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#6) On April 24, 2009 at 6:03 PM, speedybure (< 20) wrote:

this was a broad measure, if you wanna be technical you should take a/r, finished goods, inventories, and other current assets less a/p, accruals, and other current assets= non-cash working capital, then you take the change so the wc in N- N1. Kodak in the 90's was reporting great earnings for a while but had so much excess workin capital they went bankrupt(or nearly bankrupt : can't remember). The best way would to be ncwc% rev for 3-5 years etc.

thats not what i was tryin to say really, my point was eps is not true earnings because part of it needs to be reinvested. Also look at coca cola or xto 10-k that spans 5-10 years, their ppe increases every year. In ppe, i also should have included aquisitions if thats how they choose to grow, etc. 

eps is not available to shareholders because without constant reinvestment, there will be no growth. remember amazon?? Free cash flow is the portion of earnings that doesn't have to be reinvested.  

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#7) On April 24, 2009 at 6:23 PM, speedybure (< 20) wrote:

to make it easier, free cash flow can be determined by net operating profit - capital expenditure - aquisitions + depreciation. that is a very rough measure if you dont wanna determine working capital.

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#8) On April 25, 2009 at 1:38 AM, DonnerDiv (34.24) wrote:

Speedy:

 Look at a cash flow statement from any significant corporation.  Start with MMM or PG.  CASH FLOW.  Learn how to interpret the contributions from Operating Cash Flow, Investment Cash Flow and Financing Cash Flow.

You are WAY over your pay grade here.

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#9) On April 25, 2009 at 1:54 AM, DonnerDiv (34.24) wrote:

Speedy:

You have no notion of what you are talking about.  No more gloves-on gentle talk.  You are an idiot re accounting.  You have no idea of what the Hell you are talking about.

Go study at least one hour of accounting re Operating Statements, Balance Sheets and Cash Flows, all of which are available for any corporation traded on the public markets.

Get back to us when you have a clue.

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