Does a High P/E Ratio Mean a Stock is Overvalued?
The Answer May Surprise You!
Readers of this site know that Im an unabashed, dyed-in-the-wool value
investor. Yet, a mistake many people tend to make is to associate this
with only buying low price-to-earnings ratio stocks. While this
approach has certainly generated above-average returns over
long-periods of time (see Tweedy, Browne & Companys publication What
Has Worked in Investing), it is not the ideal situation.
Understanding Intrinsic Value and Why Different Businesses Deserve
Different Valuations
At its core, the basic definition for the intrinsic value of every
asset in the world is simple: It is all of the cash flows that will be
generated by that asset discounted back to the present moment at an
appropriate rate that factors in opportunity cost (typically measured
against the risk-free U.S. Treasury) and inflation. Figuring out how
to apply that to individual stocks can be extremely difficult
depending upon the nature and economics of the particular business. As
Benjamin Graham, the father of the security analysis industry,
entreated his disciples, however, one need not know the exact weight
of a man to know that he is fat or the exact age of a woman to know
she is old. By focusing only on those opportunities that are clearly
and squarely in your circle of competence and you know to be better
than average, you have a much higher likelihood of experiences good,
if not great, results over long periods of time.
All businesses are not created equal. An advertising firm that
requires nothing more than pencils and desks is inherently a better
business than a steel mill that, just to begin operating, requires
tens of millions of dollar or more in startup capital investment. All
else being equal, an advertising firm rightfully deserves a higher
price to earnings multiple because in an inflationary environment, the
owners (shareholders) arent going to have to keep shelling out cash
for capital expenditures to maintain the property, plant, and
equipment. This is also why intelligent investors must distinguish
between the reported net income figure and true, economic profit, or
owner earnings as Warren Buffett has called it. These figures
represent the amount of cash that the owner could take out of the
business and reinvest elsewhere or spend on diamonds, houses, planes,
charitable donations, or gold-plated fine china.
In other words, it doesnt matter what the reported net income is, but
rather, how many hamburgers the owner can buy relative to his
investment in the business. Thats why capital-intensive enterprises
are typically anathema to long-term investors as they realize very
little of their reported income will translate into tangible, liquid
wealth because of a very, very important basic truth: Over the
long-term, the rise in an investors net worth is limited to the return
on equity generated by the underlying company. Anything else, such as
relying on a bull market or that the next person in line will pay more
for the company than you (the appropriately dubbed greater fool
theory) is inherently speculative. I dont know about you, but I dont
want to be in doubt about my ability to retire comfortably.
The result of this fundamental viewpoint is that two businesses might
have identical earnings of $10 million, yet Company ABC may generate
only $5 million and the other, Company XYZ, $20 million in owner
earnings. Therefore, Company XYZ could have a price-to-earnings ratio
four times higher than its competitor ABC yet still be trading at the
same value.
The Importance of a Margin of Safety
The danger with this approach is that, if taken too far as human
psychology is apt to do, is that any basis for rational valuation is
quickly thrown out the window. Typically, if you are paying more than
15x earnings for a company, you need to seriously examine the
underlying assumptions you have for its future profitable and
intrinsic value. With that said, a wholesale rejection of shares over
that price is not wise. A year ago, I remember reading a story
detailing that in the 1990s, the cheapest stock in retrospect was Dell
Computers at 50x earnings. Thats right had you bought it at that
price, you would have absolutely crushed nearly every other investment
because the underlying profits really did live up to Wall Streets
expectations, and then some! However, would you have been comfortable
having your entire net worth invested in such a risky business if you
didnt understand the economics of the computer industry, the future
drivers of demand, the commodity nature of the PC and the low-cost
structure that gives Dell a superior advantage over competitors, and
the distinct possibility that one fatal mistake could wipeout a huge
portion of your net worth? Probably not.
The Ideal Compromise
The perfect situation is when you get an excellent business that
generates copious amounts of cash with little or no capital investment
on the part of the owners relative to the profits at a steep discount
to intrinsic value, such as American Express during the Salad Oil
scandal or Wells Fargo when it traded at 5x earnings during the real
estate crash of the late 1980s and early 1990s. A nice test you can
use is to close your eyes and try to imagine what a business will look
like in ten years; do you think it will be bigger and more profitable?
What about the profits how will they be generated? What are the
threats to the competitive landscape? An example that might help: Do
you think Blockbuster will still be the dominant video rental
franchise? Personally, it is my belief that the model of delivering
plastic disks is entirely antiquated and as broadband becomes faster
and faster, the content will eventually be streamed, rented, or
purchased directly from the studios without any need for a middle man
at all, allowing the creators of content to keep the entire capital.
That would certainly cause me to require a much larger margin of
safety before buying into an enterprise that faces such a very real
technological obsolesce problem.
