PE Ratios are irrelevant: two erroneous metrics lead to an erroneous conclusion

| Photography by Dan Proud
 

Talk of PE ratios is as popular as ever, even amongst investment professionals. At Blue Oceans Capital, we don’t recognise them as valid. Let me explain.
The stock price (P) is just the market price of a share in a company at any given point in time – it’s not a company valuation. The market moves every day due to factors that have nothing to do with individual companies. When the stock price does move due to factors actually relating to the company in question, it more often than not moves too far or too little in proportion to the new information. If the stock price matches a fair value it does so by chance, not design.
Earnings (E), comes from net income. Net income is an accounting calculation specifically for tax purposes. Net income is not actual cash flow from the business. It does not consider actual cash movements. For example, actual cost of asset replacement versus generic depreciation schedules, actual warranty expenses vs warranty reserves, amortisation of goodwill, capitalisation of intangibles, etc.

Blue Oceans Capital holds investments for the long-term. Read more about our performance and investment philosophy.

Implications

If you put P with E you don’t have an answer, you don’t have anything. To find value in stocks you will have to do three things. First, look at the business model and assess cash flow production and future prospects; second, value that company, discounting its future cash flows to today; and third, compare that valuation to the market price.

Assessing the business model
Is the business model sustainable, in that can it be sustained? By that I mean is this a business model that solves a problem in a manner that society approves of, and will likely require this need to be met, in this way, for a long time into the future? What are the drivers of price and volume? Can you understand them and do you know what influences them? To us this is the most important of the three parts of valuation. You can get your valuation wrong and still do well if you do this right.

Value the company using discount cash flows
We need to add up all the cash flows this company will produce into the future and discount them back to today’s value. In doing that we need to make a few assumptions. How far into the future are we confident in making cash flow projections? What growth rate from today will we assign to future cash flows? What rate will we use in discounting those cash flows back to today? There are a few other parts to this to consider. At Blue Oceans Capital we think of valuations as buying the entire business today, collecting its cash flows over a period of time and then selling the whole business at some point in the future.

Compare that valuation to market price
The final step is to compare the valuation of a sound business model to the market price. Only at this point can we determine if the company represents value or not. If the stock price is high then the market has already valued in the company’s future earnings in today’s price. If your company has good fundamentals, then a fair or discounted price may represent a buying opportunity.

PE ratios are two erroneous metrics put together from which one can infer nothing. You cannot find value simply by looking down a list of PEs. At Blue Oceans Capital, we first scan for sound business models. This means manually looking over thousands of companies to understand their business models. Only after we have a small selection of companies that interest us do we then value them. Our final step is to compare that valuation to the current market price. If the price is too high we continue to watch the company’s developments and wait for a market pullback to take a position. In our opinion this is the only way to accurately find value investments.

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