Thursday, 3 May 2012
Does a High P/E Ratio Mean a Stock is Overvalued? The Answer May Surprise You!
A mistake many people tend to make is to associate this with only buying low price-to-earnings ratio stocks. While this approach has certainly generated above-average returns over long-periods of time (see Tweedy, Browne & Company’s publication What Has Worked in Investing), it is not the ideal situation.http://beginnersinvest.about.com/od/beginnerscorner/a/aa021207a.htm
All businesses are not created equal. An advertising firm that requires nothing more than pencils and desks is inherently a better business than a steel mill that, just to begin operating, requires tens of millions of dollar or more in startup capital investment. All else being equal, an advertising firm rightfully deserves a higher price to earnings multiple because in an inflationary environment, the owners (shareholders) aren’t going to have to keep shelling out cash for capital expenditures to maintain the property, plant, and equipment. This is also why intelligent investors must distinguish between the reported net income figure and true, “economic” profit, or “owner” earnings as Warren Buffett has called it. These figures represent the amount of cash that the owner could take out of the business and reinvest elsewhere or spend on diamonds, houses, planes, charitable donations, or gold-plated fine china.
In other words, it doesn’t matter what the reported net income is, but rather, how many hamburgers the owner can buy relative to his investment in the business. That’s why capital-intensive enterprises are typically anathema to long-term investors as they realize very little of their reported income will translate into tangible, liquid wealth because of a very, very important basic truth: Over the long-term, the rise in an investor’s net worth is limited to thereturn on equity generated by the underlying company. Anything else, such as relying on abull market or that the next person in line will pay more for the company than you (the appropriately dubbed “greater fool” theory) is inherently speculative. I don’t know about you, but I don’t want to be in doubt about my ability to retire comfortably.
The result of this fundamental viewpoint is that two businesses might have identical earnings of $10 million, yet Company ABC may generate only $5 million and the other, Company XYZ, $20 million in “owner earnings”. Therefore, Company XYZ could have a price-to-earnings ratio four times higher than its competitor ABC yet still be trading at the same value.