The most-quoted metric in discussing common stocks is their ratio of price-to-earnings (P/E). This states the relationship between what a stock costs and what benefit it produces.
Many people wrongly believe that value investing involves finding companies boasting low P/E multiples, but:
- not all low P/E stocks are good investments, and
- not all high P/E stocks are bad investments.
- Nor do value investors consider the P/E ratio as an insightful measure for valuation purposes, though it might be useful as a check against overpaying.
The P/E ratio can be used as a screen.
Graham avoided buying stocks unless they were priced at their lowest P/E level during the prior five years.
He also required an earnings-return compared to price (current earnings divided by price = earnings yield) at least twice that prevailing on high-grade corporate bonds.
Other value investors follow these practices. The devices protect against the whims of the marketplace. The market might not be right, but this approach limits the value investor’s exposure from it being wrong.
Value investors resist the temptation to use P/E ratios as supplements to a traditional valuation analysis. This contrasts with devotees of pure DCF analysis in valuation exercises.
When the latter’s results show a wide range of plausible valuations, they often appeal to the P/E ratios of comparable companies as a way to narrow the range.
The approach compares the price of comparable companies to their respective cash flows (P/CF). Suppose a comparable company’s P/CF ratio is 10 (suppose a price of 20 and cash flows of 2). That ratio of 10 is then applied to the subject company. Say its cash flows are 3. Its implied comparables-based value is 30. How much this helps is uncertain. The effort relies entirely on the quality of market pricing for the comparable company. While many finance professionals employ the technique, most value investors do not consider it useful.
Value investors consider the income statement and the balance sheet as sources of information concerning business value. These are superior to market-oriented tools such as the P/E ratio for two reasons.
- First, return on equity captures the full accounting picture, including debt and equity, whereas P/E severs earnings from the balance sheet.
- Second, return on equity is an intrinsic or internal valuation methodology, whereas P/E ratios are products of market or external or valuation processes.
Market metrics (P/E) tell value investors more about Graham’s Mr. Market than about intrinsic value.
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