The P/E ratio is the most popular and the MOST abused and misunderstood valuation ratio. Let's discuss this.
Disclaimer: The companies used are only for illustrative purposes. NOT FINANCIAL ADVICE!
We keep hearing this ratio when people talk about buying stocks, especially old people. The problem is, most of these people have never really tried to dive into the P/E ratio. Just simple rules of thumb that make no sense: "P/E of over 40 is expensive". Yeah, right. Look, on paper, it is a simple ratio: The market price of the stock divided by the earnings per share of the company. Well atleast it seems simple. Price is easy to see. Earnings are subjective. What do we consider as earnings? Do we adjust for Other Income? Extraordinary items? Do we deep dive into notes to accounts to see breakup of the numbers? It is a pain and I am so glad that I don't actually work as an equity research analyst. Can't imagine myself doing these adjustments regularly. Anyways, I am not diving into all that. The problem is whenever we buy something in the market, our expectation is the company will continue doing well in the future, that is, generate lots of cash, so basically the stock price will go up and some day down the line, we sell to someone else.
The company's market price is always going to reflect the expected future cash flows. People pay to buy Tesla shares not because it is making a lot of money today, but because they expect it to generate a LOT of cash in the future and become the world's leader in the EV segment (I am not talking about stock traders here). That is why Tesla has a high P/E of something like 900. It is not a profit making company, but the market expects it to have insane profits in the future. It may not turn out to be true, but then that is a risk we take on faith, research, belief etc. when investing.
But, the story does not end here. We're not just talking about future cash flows and profits here. We're also talking about reinvestment. Let me explain. Suppose you start selling ice cream in front of a school. It takes you $1000 to setup everything like a counter, machines etc. (this is your capital). You sell ice cream worth $600 on first day and the cost of all that ice cream (ingredients) to you was $500. You make a 20% profit margin [(600-500)/500], not bad for first day. Your return on capital is 10% (Profit/Capital. In this case, $100 profit divided by capital of $1000). The next day, you want to sell more, but to sell more you need to increase your capacity. So out of the $100 you made on the first day, you put in $50 more in your capital. So your capital now is $1050. Remember, the first day, your return on capital was 10%. If you want to maintain this, now you will have to earn a profit of $105 on second day because your capital now increased. So let's just pretend you made a profit of $105 the next day. This is great. You maintained your return on capital. So, on the first day, you made $100, of which you put back in $50 to expand your capacity and earn more. Next day, you earned $105. In total, the cash that you get to keep is $105 (second day earnings)+$50 (first day earnings)=$155.
But, what if, when you reinvested $50, you could not maintain 10% return? What if on the second day, you made only $100 again instead of $105? Your return on capital for second day went down to 9.5% (100/1050). You did not invest the additional $50 efficiently. Or what if you earned more than 105. If you earn 110, your return is 10.47% (110/1050). You made an excellent reinvestment. Suppose you have 2 businesses now instead of 1. The 1st business reinvested $50 inefficiently and earned 9.5%. The 2nd earned 10.47%. Which business is worth more? Which is a better business? The second business. They generated more cash. They were more efficient capital allocators. They can earn more by investing less.
We went on a tangent here. But this is exactly what we should be using to judge P/E ratios. Are the businesses able to grow by making better returns on capital (earn $110 the next day instead of only $100 after reinvesting $50)? Are they able to generate more cash with less reinvestment? Are they reinvesting too much for too little? Companies that are not going to grow very well in the future and are wasteful with reinvestments will have a lower P/E. They are not cheap, they are just bad at reinvesting. Companies that may seem expensive may be having excellent returns on capital and big expected growth in earnings. We need to look at P/E in this whole context. You can play with the spreadsheet for this here. It is not a well formatted spreadsheet, but you can get the point. You can also read more by diving into Credit Suisse's note on this.
Okay, let's look at some real companies and see how their P/Es stack up.
HERO MOTOCORP:
I discussed this valuation earlier too. I projected out the company revenues, margins and reinvestments to arrive at the value of the company. Don't worry about how we made these projections as of now. If you want to understand this process, I have written a guide on where you can go.
The ROIC (Return on invested capital) stays between 18-20% in my valuation. The implied P/E based on these assumptions is 21. I find the company fairly valued. You can explore my sheet here. The P/E is pricing in moderate growth rates and assumes similar reinvestments going forward as they are now.
Alkyl Amines:
This is a valuation a friend of mine did. He projected out his own growth rates for the company. The company had an insane ROIC of 48% last year but my friend expects it to go down over time. The company also has insane margins and growth expectations, which is why its price has recently rallied like anything.
The implied P/E pricing in these high growth rates comes out to be 28. It is all about reinvestments and growth. My friend does find the company overvalued as current P/E is 47. But that is not the point. The point of this whole post has been to illustrate the P/E is about the expected growth rates, cash flows and capital efficiency and reinvestments. You can't just look at P/E as a single standing ratio and make your judgements across companies or markets. There is more nuance to this. Investing is a simple but risky venture. I hope this post was helpful in helping to demystify the P/E ratio. As always, you can play around with the spreadsheets that I have attached and do read the note by Credit Suisse that I have attached above.
Edit: I did not include the impact of interest/discount rates in the P/E ratio but that is definitely an important part of the equation. The excel sheets include that and you can play with them to see how discount rates factor in.
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