#7 Investing 101: How To Think About The PE Ratio?

High PE is not always bad and low PE is not always good. So, how should you really think about the PE ratio?

There are magic numbers in every game.

In soccer, it’s three. If a player scores three times in a game, it’s called a hat-trick. Children playing street-soccer gain 1 penalty for every 3 corners.

In basketball it’s 10. If you do 10 points and 10 assists, it’s double-double. If you add 10 rebounds too, it’s a triple-double.

In investing it tends to be 15.

Why? Largely because it’s a threshold beyond which stocks are thought to start becoming expensive.

It’s been established this way since Benjamin Graham suggested in the Chapter 14 of The Intelligent Investor that a defensive investor should not pick a stock that trades above 15 times earnings 👇

However, as most of the mainstream knowledge, this is not actually true.

If the company is growing 80% annually, would you say 25 times earnings is expensive? Of course not. On the other hand, 15 times earnings could be an expensive price for a dying company.

Benjamin Graham of course knew this, but keep in mind that The intelligent Investor was a book designed for the general public. A clear cut rule would simply be more accessible to a wide audience than chapters explaining intricacies of the PE ratio.

In reality, PE ratio means nothing if you don’t understand the business.

“Earnings multiples is not valuation,” Michael Mauboussin says, “it’s a shortcut.” This is probably the best definition of the PE ratio I have heard of so far.

PE ratio simply implies the prospects of the business attached to it by the market. As an intelligent investor, you should understand whether what’s attached by the market fits with the fundamentals of the business. Only then you can say:

• It’s overvalued if what’s implied looks unrealistically long-shot for the business.

• It’s undervalued if what’s implied largely understates the business’ potential.

So, what’s implicit in the PE ratio? How should you think about it?

In essence, there are 4 core properties implicit in PE ratio:

• Size.

• Growth.

• Industry.

• Capital structure.

So, how do those factors affect earnings multiples, in what way and how should you factor them in your analysis?

We are going to discuss this today.

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1. Size Matters

This should have actually been a very intuitive point but most people overlook this.

I think the reason is simple: Most people don’t think of themselves as partial owners of the business they invested in.

But this is what you are, as a common stock investor, you are a partial owner of the business because this is what common stocks represent: Ownership interest in the business. It’s easy to forget this when analyzing dozens of stocks in a day as if they were just tickers on the screen.

You should always remember, as Peter Lynch says, “a share is not lottery ticket, it part-ownership of a business.”

Thus, you have to think like an owner of the business to have the right angle.

This change of angle from a trader to an owner becomes especially useful in analyzing companies that have similar growth rates and different sizes.

Here is an example:

-Business A

• Net earnings: $10 million

• No growth.

• Trading at 12 times earnings.

-Business B

• Net earnings: $100 million

• No growth.

• Trading at 20 times earnings.

Which one would you buy?

Trader mindset forces you to buy A because it trades at a lower multiple than B. Given that both have no growth, this should mean that A is cheaper.

Yes, A is of course cheaper, there is no doubt about that.

The question is which one is a better investment? A or B?

Now, let’s try thinking like an owner and assume that you will buy one of these businesses with an intention to hold them forever.

If you buy business A, at the end of 21 years, it will make you $210 million. If you deduct the $120 million you paid to acquire it, you will be left with $90 million at the end of the 21st year.

If you buy business B, at the end of the 21st year, it will make you $2.1 billion. If you deduct $2 billion you paid to acquire it, you will be left with $100 million.

You see what happens? Despite having paid a much larger multiple for the second business, it justified its price and made you more money than business A at the end of 21st year.

Yes, your return on investment is higher in Company A but as an owner, Company B will add on your net worth that Company A would take 10 years to match. This has some value. It deserves some premium.

This is why size matters.

All else like the industry, margins, debt structure being equal; the larger company gets a higher multiple. This is clearly illustrated by the multiples in M&A transactions.

As you see above, multiples tend to increase consistently as the deal size grows. This is because of the reasoning I just explained above.

However, in order to rely on this reasoning, you have to think like an owner who intends to hold the business forever.

If you want to hold the business for just just 15 years, buying the business B in our example doesn’t make any sense because you won’t have any positive return on investment by that time. The business A, on the other hand, will have already generated positive returns by then.

You can easily decide the cheaper investment by looking at the raw data, but you can only see the better long-term investment by thinking like an owner.

Size illustrates the point.

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2. Growth Rules Them All

All the factors affecting the multiples are important, however the growth has undeniably an overriding effect on what multiple the company gets.

This is not because it’s unequivocally more important than others but because the market affords it a greater importance.

It’s almost like “The One Ring” in the Lord Of The Rings.

One ring to rule them all. Growth to rule over size, industry, capital structure and dividends…

You can easily observe this phenomenon in other markets too.

Take venture capital as an example, where the growth is the North Star and no growth is the cardinal sin. As long as you have traction and growth, venture capitalists will be willing to pour money on you. If you have no growth, you can’t raise a penny.

Why is that so important?

Simple. Because growth is the primary way companies create shareholder value. Companies resort to other ways like M&A to actually fuel the growth and when they can’t do even that they engineer growth by buying their own stock.

Without promise of growth, there is no future value to be created that could attract potential investors.

Naturally, faster the company grows, higher multiples investors are willing to pay. And this is not just an illusion. They are willing to pay more because the growth justifies it.

Let’s see an example:

Companies A and B operate in the same industry, they have the same capital structure, size and dividend policy. All other material factors are also the same. What’s different is growth.

Company A grows its net operating profit after tax (NOPAT) 30% annually while company B grows 20%. They both make $10 million in Year 0 and Year 1, then they grow.

For convenience, assume that all NOPAT is translated into free-cash-flow and growth comes from efficiencies, pricing power etc and the operations will be wound up at the end of the 10th year.

Let’s see how their NOPAT grow overtime:

In its 10 years of lifetime, Business A generated $424 million for the owner while Business B generated $259 million.

Let’s discount all the cash flows back to Year 0 at 10% to see how much we could pay for the business in Year 0 and still expect a 10% annualized return on our investment.

After discounting them back, we get that the value of the future earnings for the Business A in Year 0 is $200 million, and it’s $130 million for the Business B.

This means that we could pay 20 times earnings in Year 1 for Business A and expect 10% annualized return on investment while we could only pay 13 times of the earnings for Business B to generate the same return on investment.

As you see 10% higher growth allowed us to pay 53% higher price for the business and we still generated the same return.

This is why investors like Warren Buffett and Terry Smith emphasize the quality and defend paying up for the quality.

Faster growth rate and bigger size warrant higher multiples.

However, size is also a limiting factor on growth. It’s way harder to turn a $1 trillion company into a $2 trillion company than doubling the size of a $100 million company.

This is why mega-cap companies like Amazon and Google that also grow at above average rates keep justifying higher multiples over the long-run. They are simply deviations from the norm.

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3. All Industries Are Not Equal, But Why?

You have probably seen generalized tables that show mean and median PE ratios for different industries.

Investors would avoid a utility selling at 30 times earnings but when it comes to chips, 30 times earnings is considered “fair.”

Why is that?

Of course growth and the size of the industry affect but I believe the main distinction comes from the industry characteristics.

In old industries, like manufacturing, most of the investment is material in the form of machinery, plant and other equipment. After all, this is how those companies make money: They buy the plant and equipment, they produce something physical and they sell it.

Their investments in plants and machinery are recorded as assets in the balance sheet and depreciated over their useful lives. For instance, think about a machine that was bought for $500k with a useful life of 10 years. Instead of deducting it from the earnings, it’s recorded as an asset on the balance sheet and depreciated for 10 years, $50k each year.

This means that earnings of the company take a $50k hit every year for 10 years.

However, in digital markets, most of the investment is tangible. They don’t invest in machinery, they invest in people, software, branding etc…

Given that such investments cannot be exactly valued, they can’t be capitalized. So what happens? They are recorded under research & development (R&D) and selling, general and administrative (SG&A) expenses. Together, they are considered as operating expenses and deducted from gross profit. Result? Earnings take a bigger hit on paper but the cash flow, real value driver, doesn’t change. So, on paper, you get a higher earnings multiple.

This is how industry dynamics play a substantial role in determining the average and median PE ratios for different industries.

Of course there are always exceptions, but for the reason explained above, you can assume higher PE ratios as the share of intangible investments grows.

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4. Capital Structure

This is actually pretty straightforward.

The main reason capital structure affects earnings multiples also comes from the way net earnings are concluded.

As you know we reach earnings after deducting depreciation, amortization, interest and taxes from EBITDA.

Now, why would a company pay interest? It only pays interest if it has debt.

Interest on debt is deducted from operating income so it makes sense that companies with higher debt will pay more interest and as a result their earnings will take a bigger hit.

So we get that weird phenomenon: Two companies identical at every property, except one has debt and one not, trade at different earnings multiples despite trading at the same EV/EBITDA multiple.

Michael Mauboussin illustrated this point in one of his papers:

As you see above, the company that has debt and pays no taxes trades at a higher PE multiple than the one that has no debt and pays no taxes.

It’s simple, interest on debt is deducted from EBITDA and thus you are left with less net profit despite the fact that your enterprise value hasn’t changed.

So, again, as a rule of thumb, more leveraged the company, PE tends to go higher.

This is not special to debt. Everything that you deduct from EBITDA tends to increase the PE ratio. So, maybe we can derive one more conclusion from this:

What’s the ideal way to finance operations?

It should be a combination of debt & equity and debt should be large enough to create a tax shield and small enough not to endanger business.

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Conclusion

Most beginners think high PE ratios necessarily indicate very expensive prices for the stocks so lower the PE ratio, better it is.

It couldn’t be far from the truth.

Those who have a bit better command on the relationship between PE ratio and the pricing tend to believe that a fairly valued business will always have a PE ratio equal to its growth rate.

Though growth has an overriding effect on PE ratios, it’s not the sole factor that determines what multiple a business gets.

Size, growth, industry and capital structure interact with each other in millions of unique ways to determine the PE ratio. This is why PE ratio is often unreliable as a value signal.

More you know about what a particular PE ratio implies about the properties of the business and future expectations, the better you will judge whether the multiple it takes is fair or not.

Once you have a good understanding of how the above factors generally affect multiples, PE ratio may become a helpful shortcut for you. In other words, you gain the right to use it as a shortcut.

However, if you rely on the shortcut without understanding the implications and whether they hold true for the particular business you are looking at, it will likely mislead you more often than not.

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That’s all friends!

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