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P/E Ratios – You’re Doing it Wrong

Jordan S. Terry

April 18, 2015

The beauty of markets is that they rely on participants having different views on the various factors that

drive an asset (stock’s) price. Unfortunately, since I started following markets around fifteen years ago,

it seems fewer and fewer people care about – let alone understand - these factors, and instead, reduce

the question of whether a stock is cheap or expensive down to the lowest common denominator. While

there is no shortage of relative valuation metrics, the most often cited is the price-to-earnings or P/E

ratio.

This deceptively simple ratio is used with reckless abandon day-in and day-out, by novices and those-

who-should-know-better, bulls and bears” short- and long-term traders, and worst, self-described

fundamental value investors. If you’re really curious why I say “with reckless abandon” and have a few

minutes on your hands, Aswath Damodaran, prominent finance professor at NYU’s Stern School of

Business1 has a pretty comprehensive presentation on the topic. For those lacking the time and/or

intellectual curiosity, I’d like to focus on one of the very basic ways investors and commentators

misuse/abuse the P/E ratio, to their own detriment.

You Can’t See Much From 30,000 Feet Up

99% of the time I see a reference to P/E ratios in the context of whether a stock (let alone “the

market!”) is cheap/fairly-valued/expensive, the analysis essentially stops there. “How much is the stock

price up this year?” and “Did last year’s EPS miss or beat?” Sometimes I see vague references to

historical levels (another practice fraught with peril), growth rates, and even margins. The problem with

this approach is that you’re pulling numbers arbitrarily out of the sky (or elsewhere) without really

understanding them, and thus any P/E comparison or analysis you make is, at best, silly.

This is all well and good if you don’t mind relying upon vague, poorly-supported (if not downright wrong)

conclusions and sounding like an idiot. If, however, you prefer to make informed investing decisions, you

have to actually understand what factors determine a stock’s P/E ratio. Let’s be clear: I’m not suggesting

that everyone become a master of fundamental analysis. I am, however, suggesting that it’s in your best

interest to get a closer look at the moving pieces that determine high-level relative valuation metrics like

P/E.

Instead of throwing them around without much thought, once you understand the basic fundamentals

that drive relative valuation ratios, you are going to become a more conscientious, and likely better

investor.

What is Price?

Rather than just some numbers on your screen, the price of a stock is the market’s collective prediction

of the present value of the firm’s future cash flows to equity. (At some point, even momentum and

technical traders have to concede this is the case.) Price, then, can be determined by cash flows, the

1 FD: I am currently taking Professor Damodaran’s valuation class.

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firm’s cost of equity, and its growth rate. This may sound like theoretical nonsense, but it makes

intuitive sense! Firms with high cash flows, a low cost of capital, and high growth are more valuable than

ones with low cash flows, high cost of capital, and low growth. This is why Facebook is worth more than

some regional telecom carrier, all else equal.

A good recent, extreme example that captures these factors is Facebook’s $22bn acquisition of

Whatsapp. Putting aside whether it was a reasonable price, FB did it for the fantastically high expected

growth, it’s value within the FB platform/ecosystem, and because it used its richly-valued stock (a cheap

funding source) to finance more than half the cost. It’s not just about growth; it’s about cash flow and

the cost of generating it. All three factors come into play.

What About Earnings?

Forecasting a firm’s future earnings is hard. If you don’t believe me, give it a try one day. Alternatively,

look at the track record of very-well educated, very experienced people who do it for a living. If it were

easy, equity fund performance would look a lot different, and sell-side analysts would regularly nail their

earnings estimates, yet such is not the case.

More to the point is that if you’re playing the relative valuation game, you’re not projecting dozens of

variables to get to earnings as you would if you were doing intrinsic valuation. And so, for calculating a

firm’s P/E ratio, for a stable-growth company, we can simply take the price and divide by current

earnings per share (EPS). Mathematically, it looks like this:

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All we’re doing to determine P/E is multiplying the fraction of a firm’s free cash flow in earnings today by

the expected growth rate, and discounting it at the difference between the cost of equity and that

growth rate. That may sound like Klingon, but I promise, you don’t need a degree in finance or a

background in investment research or banking to use this formula.

If we hold the (FCFE/Earnings) term constant at 0.58 (the current trailing ratio for the S&P 500, per S&P

CapitalIQ), the concept is easier to visualize for a range of growth rates and costs of equity:

As we expect from the fundamental P/E model, we clearly see that P/E ratios rise with higher growth

rates for any cost of equity (until R=G), and that the effect is more pronounced at higher growth rates

and where the difference between the cost of equity and growth is the smallest. Now you may be

asking, “why don’t firms just try to grow as fast as possible so that G approaches R and they get

rewarded with a higher P/E?” The simple answer is that managers really can’t run a company or finagle

accounting numbers with that sort of precision. Surely if they could, they would! Another factor is that

growth costs money, and high growth tends to cost the most. Tech startups raise money in the form of

expensive VC equity, and at the other end, leveraged buyouts (LBOs) try to boost growth (returns) with

high-cost debt. There’s no free lunch, at least in the long term.

How to Use the Fundamental Model to Analyze Firms and P/E Ratios

Here’s a simple way you can use this approach to better understand why a stock with a high (low) P/E

ratio may appear more expensive (cheaper) than it really is:

Take a firm’s stock price, current cash flow, earnings, and cost of equity – all pretty easy to get – and

calculate the implied growth rate with the above formula. Now compare that to the growth rate for the

industry, and if you’re feeling slightly more ambitious, to median levels for the past 20 years or so

(picking the time period is another topic for another time). Does the implied growth rate make sense in

this context? Is it significantly higher (lower) than the industry and/or the historic rate? Did you come

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across a U.S. regional department store with an implied growth rate of 20% when the industry and

recent historical rates are somewhere between zero and mid-single digits? Is there some reasonable

explanation why this company is going to grow significantly faster than the industry for years to come?

Probably not!2

You can use this same sort of analysis to understand what sort of growth and cost of equity is takes to

get a given P/E ratio. The trailing P/E ratio on the S&P 500 is 20.87x per the WSJ, and 20.6x via S&P

CapitalIQ. Depending on whose numbers you use or what method, you’ll get a cost of equity for the S&P

around 7.5%. From this, using the fundamental P/E formula, we can see that the S&P is pricing in a

growth rate just over 4.5%, which is interesting since the long-term estimated growth rate I see in

CapitalIQ is 8%!

Here’s the expanded table for those who prefer numbers to colored bars:

Is the S&P over/under/fairly priced? I don’t know, I’m just showing you the door; it’s up to you to walk

through it! The point is, if you just look at the P/E ratio by itself, you have no context for comparison…so

you’re just wasting your time in so doing. With the fundamental P/E model, you can look at what

growth, cash flows, and the cost of equity is across firms, industries, and time, so you can determine

which factor(s) are really driving P/E multiples. Once you have context for comparison, those

comparisons actually become meaningful and actionable!

Before I move on, I need to make one thing very clear, because in a low-rate environment, it’s quite

important: P/E is VERY sensitive to changes in the difference between R and G, i.e. the same absolute

2 But also not impossible! See Burlington Stores NYSE:BURL, which has 20% est. growth, which, after adding back a major loss on debt extinguishment, has an adjusted trailing P/E around 29x, not 63x as you’ll see quoted in every data source. Compare this to, say, Macy’s NYSE:M, with a 16x P/E, but a growth rate ½ as large. (Please take this quasi-example with a very small grain of salt as I just pulled it up in 30 seconds.)

Cost of Equity 15.00% 14.00% 13.00% 12.00% 11.00% 10.50% 10.00% 9.00% 8.00% 7.50% 7.00%

Growth R=0.15 R=0.14 R=0.13 R=0.12 R=0.11 R=0.105 R=0.1 R=0.09 R=0.08 R=0.075 R=0.07

3.00% 4.99 5.45 5.99 6.66 7.49 7.99 8.56 9.99 11.98 13.31 14.98

3.50% 5.24 5.73 6.34 7.08 8.03 8.60 9.26 10.95 13.38 15.05 17.20

4.00% 5.50 6.05 6.72 7.56 8.64 9.31 10.08 12.10 15.12 17.29 20.17

4.50% 5.79 6.40 7.15 8.11 9.35 10.13 11.05 13.51 17.37 20.26 24.32

5.00% 6.11 6.79 7.63 8.73 10.18 11.11 12.22 15.27 20.36 24.43 30.54

5.50% 6.46 7.22 8.18 9.44 11.16 12.27 13.64 17.53 24.55 30.69 40.91

6.00% 6.85 7.71 8.81 10.28 12.33 13.70 15.42 20.55 30.83 41.11 61.66

6.50% 7.29 8.26 9.53 11.26 13.77 15.49 17.70 24.78 41.30 61.95 123.90

7.00% 7.78 8.89 10.37 12.45 15.56 17.78 20.75 31.12 62.24 124.49 -

7.50% 8.34 9.62 11.37 13.90 17.87 20.84 25.01 41.69 125.07 - -

8.00% 8.98 10.47 12.57 15.71 20.94 25.13 31.41 62.83 - - -

8.50% 9.71 11.48 14.03 18.03 25.25 31.56 42.08 126.23 - - -

9.00% 10.57 12.68 15.85 21.14 31.70 42.27 63.41 - - - -

9.50% 11.58 14.16 18.20 25.48 42.47 63.70 127.40 - - - -

10.00% 12.80 16.00 21.33 31.99 63.99 127.98 - - - - -

10.50% 14.28 18.37 25.71 42.85 128.56 - - - - - -

11.00% 16.14 21.52 32.29 64.57 - - - - - - -

11.50% 18.53 25.94 43.24 129.72 - - - - - - -

12.00% 21.72 32.58 65.15 - - - - - - - -

12.50% 26.18 43.63 130.89 - - - - - - - -

13.00% 32.87 65.73 - - - - - - - - -

13.50% 44.02 132.05 - - - - - - - - -

14.00% 66.32 - - - - - - - - - -

14.50% 133.21 - - - - - - - - - -

15.00% - - - - - - - - - - -

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change in growth rate will produce a larger and larger P/E as G gets closer to R. If we use the same

FCFE/E and 8% cost of equity for the S&P, but change G from say 5% to 6%, the P/E goes from 20.36x to

30.83x. If the growth rate changes from 6.5% to 7.5%, the same 1% absolute change, the P/E jumps from

41.30x to 125.07x! Here’s an expanded version of the first chart that really shows the huge impact of (R-

G) on P/E:

This is an important concept because you’ll see a bunch of very high P/E’s in practice. More often than

not they are the result of the company earning a very low profit or having an ephemerally close cost of

equity and long-term growth rate. Low interest rates have certainly had an impact here, bringing down

financing costs so that for some firms, the cost of capital is much closer to the growth rate than would

be the case in a higher interest rate environment.

I’m loathe to encourage anyone, excepting those who do it for a living, to try to forecast interest rates

and invest accordingly, so unfortunately, I can’t tell you what long-term rate you should be using, when

rates are (eventually) going to rise, or anything along those lines. I will go so far as to warn that it’s

dangerous to assume that (R-G), broadly, will remain as low as it is now with the 10-year treasury

currently 135bps below its 10-year median.

Using the Fundamental Model in the Absence of Stable Growth

What if we’re looking at Facebook or other high-growth firms instead of department stores, firms that

are going to grow very quickly for the foreseeable future before settling into stable-growth mode? Well,

things get just a little bit more complicated…

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Few are the people who can look at this and tell you what happens to P/E ratios when each term

changes. Many, however, are those who will throw around P/E ratios for high-growth firms with nothing

more than cursory attention (if that!) paid to how the various factors affect the ratio.

Ultimately, if you’re going to use relative valuation ratios like P/E to decide if a stock is cheap/fairly-

valued/expensive and invest accordingly, you’d be very-well served to understand what’s driving that

ratio. Or, as I see far too often, you can just say “it’s growing faster (slower) than its competitors” to

rationalize why a company has a higher (lower) P/E than its peers. Sure, the stock may be growing faster

(slower) than its peers, but does that growth # make sense? What about cash flow and cost of equity?

*crickets*

And now you sound like an idiot because you don’t know what you’re talking about.

Don’t be an idiot.

Learn the fundamental factors, understand them, and embrace them. It can only help!

As always,

CAVEAT EMPTOR

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