PE Ratio Limitations – Deeper dive into PE ratio

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P/E ratio (Price-to-Earnings Ratio) is the most popular ratio used to “evaluate” a stock. I have “evaluate” in quotation marks because just looking at one ratio is not really evaluating a company. After people look at a stock price, the next thing they usually check is its PE ratio. I want to explore the PE ratio in more depth because people typically misunderstand it despite its popularity. Then look at PE ratio limitations, flaws, and ways to go from PE ratio to other valuation approaches.

What is the PE ratio, and why is it so popular?

PE ratio is the price of a stock on the market today divided by the company’s earnings per every share outstanding. Imagine a publicly-traded company that made $5 per share over the last twelve months. The company’s stock price is currently $75, and therefore the PE ratio is $75/$5 = 15.

What does that mean?

Remember if you are thinking about investing in a stock. You are thinking about becoming a part-owner of that business. So for us as investors, the PE ratio measures the multiple we are willing to pay for those earnings.

It is more challenging to understand the PE ratio when thinking about a massive publicly-traded company. So let’s instead imagine the PE ratio for a small business. If you ever thought about buying a website as an investment , believe it or not, a version PE ratio also comes up.

In 2021, websites sell for roughly 30-60x their monthly earnings. Let’s take the average of 45x. If a website is earning $5000/month in profits, it will sell for $225,000. $5000/month is $60,000 per year. That is PE ratio of $225,000/$60,000 = 3.75.

That is incredibly cheap compared to the stock market. 200-year S&P 500 average PE is 15. Websites today can make great investments; that is why we have a whole section dedicated to them here. But there is obviously a catch; they are incredibly risky investments, that is why they tend to sell for cheaper than established companies. But thinking of PE in this way makes it a lot simpler.

However, let me complicate it just a little bit.

Market view on PE ratio vs. Owner’s view

The price of the stock on the market has two components to it.

  1. Fundamental aspects to the company (like its earnings)
  2. Multiple that the market is placing on the company. This includes the emotional component like optimism or pessimism about the company’s future prospects.

The company cannot control the second component as it is up to the market. The multiple will fluctuate based on emotions about the company and the state of the economy, central bank decisions, bond markets, interest rates, weather, and many other seemingly unrelated factors. These factors can at times have more weight on the stock than the underlying fundamentals.

However, that is only true in the short term, and in the long term, the fundamental aspects will always play a more critical role.

Ben Graham, the father of value investing, had a saying that describes this perfectly:

In the short run, a market is a voting machine, but in the long run, it is a weighing machine

Thus, market opinion only matters to assess the current selling price.

Owner’s view of PE

From the investor’s perspective, the weighing machine aspect is more important. So PE ratio becomes just one of many valuation tools, and it is simply a tool to evaluate the yield that you can expect to generate if you buy the company (or a piece of the company) at the current price.

Earnings Yield (The reciprocal of PE)

Earnings / Price (Reverse of PE) gives us the earnings yield. We can compare the earnings yield to other investments from comparable companies to bonds to measure our investment’s relative soundness.

The average PE ratio of U.S stocks from 1900 until today is approximately 15, translating to an earnings yield of 6.67%. That is what you can expect from investing in the stock market. In fact 6-8% is the average S&P500 historical return since it started.

What is a good PE ratio?

PE ratio of 15 generally represents a rule of thumb for fair value of an average company expected to grow earnings 1-15% in the future. Note that future earnings growth is not part of the calculation of the current PE ratio. Also, a high PE ratio does not necessarily indicate that the company will grow earnings faster than others in the future. The multiple on those earnings paid today is not indicative of that growth. If that were the case, the strategy to go out and buy all high-PE stocks would generate good results, but the opposite is true.

Companies purchased at high multiples are riskier, and they are overbought and, in the event of a downturn, are the first ones to go.

It is important to note that a low or high PE ratio is not an indicator of future returns. You can buy a low PE stock and consistently lose money with it.

The PE ratio of a stock on its own doesn’t mean anything. It is only helpful to compare either to the industry, market, other company, or the PE of 15 if it’s an average growth company.

What is a good PE ratio for a high-growth company?

PE Ratio of 15 applies as a quick and dirty fair value reference point for many companies growing earnings anywhere from 0% to 15%. Historically it has been a great reference point that worked reasonably well. But what about really high-growth companies?

For high growth companies, a rule of thumb is

PE Ratio = Annual growth rate of company’s earnings

So for a company growing earnings at 30% per year, its fair PE Ratio would be 30.

To understand why it works so well, we need to look at the PEG Ratio or Price/Earnings to Growth Ratio.

PEG Ratio Formula

For high-growth companies, a PEG ratio of 1 is fair, and above one is overvalued, and below is undervalued. For the PEG ratio to be equal to one. PE Ratio = Annual Growth Rate.

If you want to dive deeper into why the math works out, check out, Sum of perpetuities method – Wikipedia

This concept was popularized by legendary Peter Lynch in his book One Up on Wall Street.

PE Ratio Limitations

From the above analysis, PE Ratio limitations just pop right out.

  1. PE Ratio on its own doesn’t tell me much about the company’s fair value.

It needs to be compared to other investments in the space or a fair value “benchmark” depending on its growth rate.

  1. PE Ratio does not consider company’s debt

Highly indebted businesses can generate great earnings and go bankrupt the next day. PE ratio might be low, and earnings prospects are great, but the future turns out to be different. If earnings start to decline and debt becomes unserviceable, it doesn’t matter that company’s PE was low.

  1. Companies with no earnings are excluded

This one is obvious, but we cannot calculate the ratio if the company doesn’t yet earn a profit. So you wouldn’t be able to invest in companies like Tesla or Amazon for the longest time because they did not have a PE ratio.

However, these PE ratio limitations don’t render the PE ratio useless. As I mentioned before company’s valuation is not its PE ratio or PEG ratio or EV/EBITDA ratio, or any other ratio. That is why I find it a waste of time to ponder the limitations of one specific ratio.

Why is the PE ratio so popular?

PE Ratio is popular because of how quickly it can tell us the earnings yield on a company today that we can quickly compare to other investments we are considering.

At the same time, if I am familiar with a company, I know its debt position and growth rate. PE ratio is a great quick check that I can use to see when the company reaches sound valuation horizon that warrants further investigation.

These are rules of thumb

For an average growing company, fair PE is around 15, and for high growth PE = EPS Growth rate; these are quick rules of thumb.

What goes from there is an extensive process of understanding if you want to own the business and if you can get a bargain, given future expectations and potential.

And even then, there are instances when we should ignore the rules of thumb.

For example, if you followed these rules of thumb closely, you would miss many tech giants that generated extraordinary returns over the last decade.

Here are just a few examples:

Facebook PE Ratio – 5 Year History

Facebook historical PE ratio

Tesla PE Ratio – Recent History

No earnings, so no PE ratio possible for Tesla.

Tesla historical PE ratio

And so on.

I am not necessarily suggesting that these were good companies to invest in at the time, given their valuations but their performance is undeniable.

For every rule, there are always exceptions. Companies that do not fit perfectly into a nice and straightforward calculation require further, more in-depth analysis from the start. You won’t be able to uncover them by following a rule of thumb.

But as a famous economist, John Maynard Keynes said:

It is better to be roughly right than precisely wrong. John Maynard Keynes.

Source: John Maynard Keynes quote: It is better to be roughly right than precisely wrong.

So don’t worry too much about what ratio to use and which one has more limitations. Use them to make a quick judgment on whether you should look further into a company or not.

Happy Investing!

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I started my professional career in the automotive industry long before electric vehicles were a thing despite Tesla already existing.

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