Thursday, January 14, 2010

Making The P/E Meaningful

The P/E ratio is one of the most useful metrics for determining how cheaply a company may be purchased. But as we've discussed before, it cannot simply be applied blindly; company earnings may be temporarily depressed, or may be high due to one-time gains. But even if earnings are corrected or smoothed to reflect fluctuations in the business cycle, a company's balance sheet position may be so exceptional that it also has a material effect on a company's would-be P/E.

Consider some of the strongest cash generating businesses in the world: Apple, Google, Microsoft, and RIMM. Their P/E's will often look quite high at first glance, but in some cases they are much lower after adjusting for their cash balances. The chart below illustrates this, by showing these four companies (along with cash-rich KSW, a company we have discussed as a potential value investment) with their P/E's after adjusting for their cash balances:

Clearly, the P/E ratio must be adjusted to become a meaningful figure. Furthermore, on its own it does not convey enough information to determine whether an issue warrants purchasing. The higher the P/E, the more earnings must grow to justify the price, and the more the stock price will fall if earnings growth does not come to fruition. This is why value investors prefer stocks with low P/E's, as low expectations lower the potential for loss of capital and raise the potential for price appreciation.

Disclosure: Author has a long position in shares of KSW


Anonymous said...

Although theoretically the value of a company should equal the net cash value plus earning power, investors rarely ascribe any extra value to public companies with high cash balances - unless they believe that cash will be given back to shareholders.

The typical valuation is done using strictly a multiple on earnings. Apple and Google (among others) have high P/Es because investors believe earnings will continue to rise at a meteoric clip, not because of their large cash positions. A lot of so-called value investors make the mistake of valuing these companies using this theoretical methodology even though 'the crowd' never will.

Unknown said...

Do you mean substracting cash per share from price per share?


Anonymous said...

Yes, there are several companies that look extremely attractive if you back out cash, but the market will never value them that way - unless they make a distribution.

Best said...

Taken out of context, P/E ratio alone is another useless measure of company valuation. Many other important variables must be used in context with the P/E ratio to make it meaningful. Thanks for pointing this out in the beginning of your article. Many investors are too easily swayed by seemingly attractive PE multiples, when in fact there are other important factors to consider.