PE Ratios are irrelevant: two erroneous metrics lead to an erroneous conclusion.

  1. 1 Posts.

    Talk of PE ratiosis as popular as ever, even amongst investment professionals. I don't recognise them as valid. Let me explain.

    The stock price (P)is just the market price of a share in a company at any given point in time -it's not a company valuation. The market moves every day due to factors that have nothing to do with individual companies. When the stock price does move due to factors actually relating to the company in question, it more often than not moves too far or too little in proportion to the new information. If the stock price matches a fair value it does so by chance, not design.

    Earnings (E), comesfrom net income. Net income is an accounting calculation specifically for taxpurposes. Net income is not actual cash flow from the business. It does notconsider actual cash movements. For example, actual cost of asset replacementversus generic depreciation schedules, actual warranty expenses vs warrantyreserves, amortisation of goodwill, capitalisation of intangibles, etc.

    Implications

    If you put P with Eyou don't have an answer, you don't have anything. To find value in stocks youwill have to do three things. First, look at the business model and assess cashflow production and future prospects; second, value that company, discountingits future cash flows to today; and third, compare that valuation to the marketprice.

    Assessing the business model

    Is the businessmodel sustainable, in that can it be sustained? By that I mean is this abusiness model that solves a problem in a manner that society approves of, andwill likely require this need to be met, in this way, for a long time into thefuture? What are the drivers of price and volume? Can you understand them anddo you know what influences them? To us this is the most important of the threeparts of valuation. You can get your valuation wrong and still do well if youdo this right.

    Value the company using discount cash flows

    We need to add upall the cash flows this company will produce into the future and discount themback to today's value. In doing that we need to make a few assumptions. How farinto the future are we confident in making cash flow projections? What growthrate from today will we assign to future cash flows? What rate will we use indiscounting those cash flows back to today? There are a few other parts to thisto consider. At Blue Oceans Capital we think of valuations as buying the entirebusiness today, collecting its cash flows over a period of time and thenselling the whole business at some point in the future.

    Compare that valuation to market price

    The final step isto compare the valuation of a sound business model to the market price. Only atthis point can we determine if the company represents value or not. If thestock price is high then the market has already valued in the company's futureearnings in today's price. If your company has good fundamentals, then a fairor discounted price may represent a buying opportunity.

    PE ratios are two erroneous metrics put togetherfrom which one can infer nothing. You cannot find value simply by looking downa list of PEs. At Blue Oceans Capital, we first scan for sound business models.This means manually looking over thousands of companies to understand theirbusiness models. Only after we have a small selection of companies thatinterest us do we then value them. Our final step is to compare that valuationto the current market price. If the price is too high we continue to watch thecompany’s developments and wait for a market pullback to take a position. Inour opinion this is the only way to accurately find value investments.
 
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