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Stop Relying on P/E Ratios

Significant variation in P/E ratios can happen in a single year. Here are more points to consider when valuing a stock.

By Brian Regan, CFA

I usually have financial TV on in the background during the workday. A little while back on CNBC, there was a great debate going about whether valuation matters. At first, I was baffled – of course the price you pay for a business is important. I realized soon that what Josh Brown meant was that P/E (price to earnings) ratios did not matter.

Josh Brown was mostly right.

Brian Regan

Brian Regan

Anybody that knows me knows that I think valuation is important to investing. We all want to buy companies for a lower price than the company’s intrinsic value. So, how could I possibly think that P/E ratios do not matter? It’s simple. I do not think P/E ratios are indicative of intrinsic value.

Short Term

Stocks are long term assets and their prices typically reflect that. In fact, the P/E ratios reflect that. The 25-year forward average S&P 500 P/E ratio is 16.86, reflecting that without earnings growth it would take almost 17 years to be paid back from earnings.

SP 500 Index Forward PE ratio - Regan

However, P/E ratios at a point in time are short term in nature. There are two types of P/E ratios: trailing and forward. Trailing ratios take net income from the last 12 months and divide it by the price. Forward ratios take expected net income for the next twelve months and divide it by the price. The metrics only consider a single year of earnings. Significant variation can happen in a single year.

One Time Charges

My CEO asked me at some point in 2019 if Procter and Gamble ( (PG) - Get Procter & Gamble Company (The) Report) was irrationally mispriced. We had a client that was heavily invested in PG and could not diversify immediately for several financial planning purposes, but if it was poised to crash, he wanted to be in front of it. My initial thought was that it was improbable that a company like PG was wildly overpriced compared to other consumer staples, but the CEO had noticed that the P/E ratio was well over 100 – so questioning it was very valid.

In 2019, Procter and Gamble impaired their Shaving and Grooming segment as the future income did not justify the carrying value of the business on their goodwill and thus the intangible value of the Gillette brand. The net charge was more than $8.3 billion which reduced their EPS (earnings per share) to $1.43 from $3.67 in 2018. The impairment caused the P/E ratio to dramatically change from 26 to 84 instantly. The price continued to march forward, and the next reporting period dramatically corrected the P/E.

PG Price PE ratio - Regan

Business Durability

Many readers might astutely note that PG still has a significant P/E ratio compared to the 25-year average. Intrinsic value, maybe more than anything else, is influenced by the durability and consistency of the business. Warren Buffet looks for stocks with a durable competitive advantage where he can reasonably determine the economics of the business 10-20 years from now. Even though on a P/E basis PG looks expensive at 25x, it does not mean it is necessarily the case. PG’s world-class brands have led to consistent and growing operating income over many decades that has allowed share count to fall and dividends to rise.

Compare PG’s P/E at 25 to U.S. Steel’s (ticker:  (X) - Get United States Steel Corporation Report) P/E of under 1x. U.S. Steel’s P/E seems like a fantastic bargain on the face, but the P/E is dogged by the short-term issue and a lack of business durability. U.S. Steel is a cyclical business. It had a fantastic 2021 as prices moved in its favor and demand was high, leading to the very dramatic P/E ratio of 1. It lost money in 2020, 2019, 2016, and 2015, which would have led to infinite P/E ratios in those years. The inconsistency of the business led to rising share counts and the elimination of the dividend.

Business Growth

Toward the beginning of this article, I wrote how the 25-year average forward P/E assumes an almost 17-year payback period assuming no growth. Assuming no growth over 17 years is not realistic. Many companies in the index will grow and many will even go out of business and fall out of the index entirely. The average EPS growth rate according to YCharts is 9.06% (with survivor bias). If the long-term growth rate of a company exceeds the average with proven management, then it may make sense to pay more for that asset since it will grow into the valuation.

The 10-year EPS annualized growth rate for Costco ( (COST) - Get Costco Wholesale Corporation Report) is more than 13%. The P/E ratio is 41. Costco has a durable business model with a cost advantage that is growing faster than the overall market. On the face, it may seem expensive but as we saw with PG, a premium is warranted for durability and consistency. An additional premium is warranted for excess long-term growth.

Costco PE Ratio EPS - Regan

Subscription Accounting and Cash Flow

Costco’s 10-Q dated May 8, 2022, has an operating income of almost $1.8 billion for the quarter end and almost $1 billion of that coming from membership fees. Costco charges an annual membership fee to shop at their stores. The fee is charged up front and Costco cannot realize the revenue until time has passed in the pre-paid membership. They have received the cash. They can invest that cash, but they are not getting credit for the cash in the P/E ratio. On a cash basis, the P/E ratio is artificially high because the income is artificially low. As an analyst you have the benefit of seeing the membership fees received but not yet realized by seeing the deferred membership fee liability in the balance sheet. In this case, Costco can expect to realize $2.25 billion in the next 12 months from membership fees adding to the consistency and durability of EPS.

Cash is King

Earnings and cash flow are different numbers, as we saw in the Costco membership fee example. If a business is generating gobs of cash but it is not reflecting great EPS, it could be a mistake to concentrate on the EPS and thus the P/E ratio. Amazon ( (AMZN) - Get Amazon.com Inc. Report) has consistently posted far more cash flow than earnings. There were many years in recent history where income was negative (P/E undefined), but cash flow was significant. The EV to EBITDA ratio (enterprise value to earnings before interest, taxes, depreciation, and amortization is more closely aligned to cash flow and EV includes debt) is much more reasonable than the P/E ratio in the Amazon situation. The reason for the huge disparity is the non-cash depreciation expense that largely reflects the robust real estate portfolio that possibly has appreciated in value rather than depreciated.

Amazon Cash Net Income EV to EBITDA

Selecting stocks for your portfolio is unsurprisingly more complicated than running a screen for the P/E ratio. We need to do further analysis to identify the type of company we’re evaluating considering the durability of earnings, the growth of those earnings, and if it is flowing through to cash flows. This is only a sample of the problems with P/E ratios, but we need to learn to look beyond the simplicity of ratios and comparable analysis.

Asset Management Resources, LLC (AMR) discretionary portfolios own all the stocks mentioned except Procter and Gamble including myself personally. AMR clients may own all the stocks mentioned including non-discretionary positions.

About the author: Brian J. Regan, CFA®

Brian J. Regan, CFA®, MBA, is the chief investment officer for Asset Management Resources, LLC. His responsibilities within the firm relate to investment research, portfolio design and implementation. He has education and experience in portfolio risk management, asset allocation, fixed income security selection, equity security selection, and macro-economic analysis.