Is too much importance given to P/E ratios?
P/E, or price-to-earnings, ratio is the most common method used by the market to value and assess the share price of listed companies. It can be a useful starting point when considering the valuation dynamics of a standard industrial-type company.
But, as a fund manager and contrarian investor, we often ask ourselves where its use ends and how we can add value. And, like any headline measure, P/E has its shortfalls.
First, the P/E ratio of a stock is often quoted as ‘consensus’: the sum of various sell-side or market analysts. With the sell side losing revenue and talent, more often we find market earnings expectations to be unremarkable or just plain wrong. For an active manager however, we believe this can be an advantage. Relying heavily on our proprietary research and scrutinising the key variables in a company’s P&L, we typically find companies with materially divergent market forecast expectations. This is often the case for business transformation and turnarounds – a key focus of our portfolios and investment process. We also focus on earnings two, three or five years out and regularly challenge our team to find contrarian views in our investment universe.
Second, earnings forecasts (even our own) can be misleading. As a value manager, it’s important we follow the cash. Stated profit is good, but does it translate to cash received? Cash is what ultimately allows the board and management to continue maintaining and growing the business, as well as reward shareholders. We believe price-to-free-cash flow, or P/FCF, over a reasonable time frame is a better way to judge forecasts.
Market numbers can be used to create a long-run view of trading multiples, comparisons to peer companies and more. However, valuing or determining the correct ‘P’ for a stock, in our view, is part art, part science. Changes to a company’s strategy, size, business mix, margins etc. can make a company better or worse over time, forcing us to consider whether to value cash flows differently – and ultimately, add value.
As featured in The Constant Investor