This article brings up a good point that P/E ratios don’t take into consideration earnings growth (or reductions). For example, if you think your favorite pharmaceutical company is going to take a hit due to expiring patents, then the P/E ratio won’t reflect that.
I’d love to hear your opinions (especially from the accounting wizards here) on point #3 that the author brought up. In what way can a company manipulate it’s P/E with fuzzy accounting? Assume the company isn’t doing anything illegal, but is gaming the system.
Company is in a growth mode or has a huge addressable market, in which case top-line growth, improving ARPU’s, etc. matter more to investors than earnings, especially if company is reinvesting in the biz to build a moat (e.g. AMZN, NFLX, P, etc.). Fixation on EPS and sometimes even EBITDA often leads value investors to wrong conclusions on a company that may look expensive today, but is actually cheap on future year numbers.
P/E can understate or overstate valuation for cyclical companies
E can be easily manipulated
E can be very valuable and lead to very different conclusions about valuation if using trailing vs. forward (e.g. declining businesses will often screen cheap on trailing numbers, but are expensive on forward numbers because their competitive advantage is being eroded)
E can be depressed because of leverage, leading investors to conclude that a company may be more expensive than peers when in fact on a capital structure-adjusted basis (e.g. unlever and relever beta), that company may actually be cheaper
Consensus is flat out wrong about estimations for “E”
Also suggest that you read my article series on Mergers & Inquisitions. I talk a bit about the importance of using mlutiple valuation methodologies in arriving at valuation because P/E may be unreliable or simply irrelevant.
Or you could just make revenue up out of thin air. Say you own a clothing store and sell T shirts at $4 and keep $2 as gross margin. If your sales are $100 (25 shirts), you would then keep $50 for your gross margin. In order to double your GM, just say you sold 12.5 more shirts (make this number up). 12.5*4 = $50. Since these are made up sales, you won’t have a COGS with it. If your enterpirse is large enough, you could easily hide this within your stack of purchase orders. An auditor would need to pop a whole box of No Doz to figure this out. An analyst would not be able to uncover this. Why you may ask? Analysts don’t have access to the internal accounting books such as purchase orders and what not.
Extreme example above, but you can easily see how earnings can be manipulated. For that reason, we as analysts rely on free cash flows FCFF/FCFE. Earnings, EBITDA, and Sales are not equal to cash. Follow the money little cubby.
Totally agree with CFAvsMBA. Also, you should buy a copy of Financial Shenanigans and Quality of Earnings right now. That will give you more info on the topic than perhaps you even cared to know, but you should do the actual legwork yourself. There is plenty of literature on the topic.
How would the cash flow statement tie out if the example you gave took place? What’s the debit entry, AR? How would management keep AR current on these fictitous sales?
AR as a whole would grow at the same rate as sales revenue in theory which would not be a cause for concern. But, since this sales revenue is not real, AR DSO will increase each period. Unless or until real sales can save the day, the scheme will crumble within a few periods.
And that’s why we focus on it. Earnings can be just a good (but fictional) story. Cash is for real.
As a prof, I’m always surprised that more curriculums don’t focus more on the statement of cash flows. I run our student-managed fund, and the students have to do old-school DCF valuations. When I’m done with them, they know how to tear apart a Cash Flow statement (and more thoroughly than our accounting majors).
^ It’s sad, so many undergraduate business programs almost completely ignore the CFS. I can no longer count the number of recent grads we’ve hired who had no idea where to find depreciation expense if it wasn’t broken out in the IS.
A high PE should indicate either “overpriced” or “extra safe” (I.e. justified). It’s the analyst’s job to figure out which it is. What’s happening in a high PE situation is that people are buying the thing because it’s percieved to be a safer or more assured bet than comparable firms (per dollar of expected profit), and that’s driving up the price. One key question is whether this percieved safety is justified, which is where the digging into accounting practices that CvM talks about is key.
A high PE may also indicate high growth potential, and I personally tie this into my mental model by saying that if future growth is reliably there, then it is a source of safety, because the growth prospects provide a kind of cushion for expected capital appreciation. You’ll get value out of the profitability of existing business, and then some extra value out of how fast you grow. This is one reason that high PE companies are frequently called “growth” companies (though many people prefer to use PB instead).
You could say that high PE is “overpriced,” “extra safe,” or “has growth potential,” because maybe you don’t see growth as guaranteed or a cushion of sorts. I don’t have an issue with that perspective, other than it’s more complex to remember. Growth is very hard to estimate reliably, and people have a tendency simply to extrapolate past growth, or to fall under the spell of marketers who see 2% growth for 1 year, and then a 20% per year explosion for the next 5 as network effects and word-of-mouth marketing really starts to kick in. Most of growth is about the 1) overall size of the market (expanding or declining industry), and then 2) whether the firm is competitively set to increase market share faster than its marginal cost. It’s hard to figure that out, which is why people prefer simple extrapolation, even though extrapolation has a lousy predictive record.
The CFA has a large section about “Justifiable PEs” and other justifiable ratios. It’s pretty much all about trying to figure out how much growth is implied by the current PE ratio. From there, it’s often easier to back out what the assumptions are about revenue growth and profitability that would make such a ratio justified. Finally, you end up making a qualitative judgement about whether those assumptions seem plausible or not and how long it might take the market to come to your point of view. The better your understanding of competition and competitive structure, the better one is able to make these kinds of decisions on high PE companies.
The low end of the PE spectrum is sometimes called the value end, although traditional value investors look mroe at PB than PE. On the value end, you are trying to figure out whether the company is a “value investment” or a “value trap,” which basically means: are people running away from this company for a good reason, and what (if anything) will make them change their mind about it.
Stock options may distort PEs as well. If E is non-diluted, options are akin to a free way to reduce wage expenses. E looks bigger and, all other things equal, PE will look smaller (value shouldn’t go up as much as E just because the company chose to pay employees with options instead of money).