In my Quora feed the other day, someone asked about how one may best use P/E ratios. I took time to answer the questions because ratio analysis is one subject in which I see a lot of investors making mistakes. Ratio analysis is very useful for some people. However, if you are reading this article, you are not one of the people for whom it will be useful.
In my opinion, looking at any [financial] ratio has very, very little use for any investor planning to hold an asset (like a stock) longer than a few weeks. “Analyzing” ratios is superficially easy to do – compare Company A’s number to Company B’s number and invest in the company with the lower ratio.
To use P/E ratios effectively (rather than superficially), either you have to know a lot about accounting and have a very short investment time horizon, or you have to be analyzing ratios in the context of constructing a “basket” of stocks to invest in.
Knowing a Lot About Accounting
Regarding the first point, financial ratios from companies with different business models are not directly comparable. In order to really analyze which company is “cheaper” on a ratio basis, you have to know a lot about the operations of a company and how the company’s accounts are set up.
Financial ratios are not constants of nature, so it is not like a company will automatically be a good buy if it is trading at a low P/E ratio (see my analysis of Gilead Sciences, which is trading at a very low P/E: Don’t Trust Gilead’s P/E Ratio) , nor is it automatically overvalued if it’s trading at a very high P/E ratio (e.g., Amazon).
That said, over a period of a few weeks, ratios tend to be pretty stable, so investment bankers who specialize in IPOs, mergers and the like (whose investment time horizon is usually only a few days or weeks long) use ratio analysis a lot. Investment bankers have teams of people that know all about accounting and who are looking at the actual accounting books of the firm in question. As such, using P/E ratios to set an IPO price that will be marketed over the next day or week or so makes sense.
1585 Broadway – Morgan Stanley’s World HQ. Investment bankers have offices on the upper floors. Sales and Trading on the lower floors. The culture is very different between the lower and upper floors.
Investment Baskets
On the second point, there are certain ratios which have been shown to be efficacious. One ratio that was studied by a famous academic named Eugene Fama is the Price-to-Book ratio (most academics use the inverse ratio: “Book-to-Market ratio”). He found that you could generate superior risk-adjusted returns by buying a basket of low Price-to-Book stocks.
(Fake) Nobel Prize winner, Eugene Fama. It’s a wonder how a smart guy like this guy can doggedly stick to the Efficient Market Hypothesis when there is such a mountain of refuting evidence.
A lot of investors have heard about this research and make the fallacious assumption that all they have to do to find a good stock to invest in is to look for one that has a low price-to-book ratio.
This is not what Fama’s research says; he says that if you buy a basket of a lot of these stocks in it, the aggregate basket will outperform a basket of randomly-selected stocks. He does not say that all low price-to-book stocks will generate excess returns. It’s a subtle difference that a lot of people miss – to their detriment.
I have written a longer article about using ratios to try to value companies that was originally posted on Forbes, so I’ll just point you to that (the article’s subject is the solar company, First Solar, but I go into detail about ratio analysis there too).
The Vampire Squid Versus the Sun: First Solar ‘Valuation’
What P/E Ratios Really Represent
In essence, using a P/E ratio is a shorthand way of expressing how quickly earnings are likely to grow in the future. Unfortunately, people don’t know this, so when they use a P/E ratio, they completely obfuscate their assumptions regarding future growth.
Some people further muddy the waters by mixing in an historical growth term and analyzing what they call the “PEG Ratio.” Analyzing a company using this ratio is like trying to draw a picture of an object by looking at the reflection of the object’s shadow in a pool. Future growth is obfuscated by the P/E ratio, then confused with the historical growth value to further complicate matters.
In my mind, the best thing to do is understand how fast a company’s cash flows can grow and make a valuation based on that. I talk about how to do this in my book and on my website.
Intelligent Value Investors Value Growth