“XYZ Corp is trading with a PE ratio of 25. The stock is obviously too expensive for value investors.”
“The price earnings multiple of ABC Corp is only 8, a clear signal the company it too cheap to pass up.”
After a stock’s name and price, its “PE ratio”, short for price earnings ratio, is often its most quoted feature. Just about every investor has used the PE ratio as a yardstick to judge value. It’s such a simple concept: divide the market value of a company by its earnings. The result tells us how much investors are willing to pay for every dollar the company earns. Investors love the PE ratio because it allows them to boil down company valuation, a process that requires a bit of work, into one easy to digest number. It’s commonly assumed that a low PE ratio is a better value than a high PE ratio. But in its simplicity the PE ratio ignores one crucial element. When investors rely on PE ratios they consistently misprice opportunities, leading to big advantages for real value investors.
What a PE ratio doesn’t do very well is understand growth. I can prove it to you by illustrating how one company with a PE ratio of 20 is far more valuable than a company with a PE ratio of 10. You will never think about PE ratios the same way again.
Consider that Company A is valued at $100 and earned $5 last year. Its PE ratio would be 20 ($100 market value divided by $5 of earnings). Now let’s say Company B is also valued at $100, but it earned $10 last year. That gives Company B a PE ratio of 10 ($100 market value divided by $10 of earnings). At this point most investors and even so-called experts would say that Company B is a better value because it has a lower PE ratio than Company A. Why pay more for a dollar of earnings if I could pay less, right?
Now let’s also consider that Company A can grow earnings by 20% per year, while Company B can grow earnings by only 6%. If we add up all those future earnings, we find that Company A is worth about $380, while Company B is worth only $300.
It’s clear that buying Company B based on its lower PE ratio would be the wrong move for a thoughtful value investor. Even though Company A has a higher PE ratio, its future earnings compound at a higher rate, capturing more value for shareholders.
Over the last two months I’ve watched investors plough a lot of hard earned dough into low PE companies. Materials, energy, just about any Canadian company that found itself in the lowest 10% of PE multiples in February is now up by about 2 PE points, a massive move. And while in the short term the momentum effects of a snap-back market rally might feel good, at some point the reality of owning low PE companies sets in: they’re just not that good at consistently generating growth for their shareholders over the long term. High quality companies with growing earnings, even with their higher PE ratios, are often a much better value for thoughtful long term investors.