Tuesday 20 August 2013

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.

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.  

Value investors resist the temptation to use P/E ratios as supplements to a traditional valuation analysis.  
  • 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.
1.  First, return on equity captures the full accounting picture, including debt and equity, whereas P/E severs earnings from the balance sheet.
2.  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 tell value investors more than Graham's Mr. Market than about intrinsic value.  

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