For investors, the price-earnings ratio, or P/E, has been a staple of valuation analysis. But, should it be?
Michael Mauboussin expressed skepticism in chapter 24 of "More Than You Know: Finding Financial Wisdom in Unconventional Places."
He launched his argument with an analogy: the evolution of Social Security in the United States. When the government fund began in 1937, there were roughly 42 working people to support each retiree. Because of changes in demographics and other elements, there were only about three working people for each retiree by the time his book was published in 2013.
To summarize the situation, Mauboussin wrote, “A look at Social Security’s evolution illustrates a crucial point: It is really hard to manage a system when the underlying data are constantly changing. You can’t draw conclusions from past averages because they don’t accurately represent today’s averages.”
The same is true in financial markets. For example, investing is affected when historical-average price-earnings ratios are used to value stocks or whole markets. We have to ask ourselves, when using historical data, if the circumstances were the same throughout the period in which we are analyzing. The author wrote, “Just as no policymaker would dream of using old demographic data to assess the future of Social Security, investors should not casually rely on past price-earnings ratios to understand today’s market.”
That’s because the statistical properties of a population must be relatively stable over time if we are to take any lessons from price-earnings over time. When the population is unstable, in the sense of changing significantly, then applying past averages to today’s population could produce misleading conclusions.
According to Mauboussin:
“Theoretical and empirical analysis of price-earnings ratios suggests that they are probably nonstationary. In fact, research shows that there has been no statistically significant relationship between a price-earnings ratio at the beginning of a year and the subsequent twelve- and twenty-four-month returns over the past 125 years. More bluntly, the historical-average price-earnings ratio provides investors little or no guidance about market returns over the typical investment horizon.”
There are three main drivers that explain why populations are not stable: taxes and inflation, changes in the economy and changes in the equity-risk premium.
First, taxes and inflation. We know that investors price their assets with the aim of bringing in an appropriate net return (i.e., after taxes, inflation and transaction costs). Thus, when there are increases in dividend or capital gains taxes, investors need higher pre-tax returns to stay even. And higher taxes must lead to lower multiples, and vice versa. American tax rates, on both dividends and capital gains, have varied a great deal since the 1960s, but overall have come down.
On the inflation side, the same dynamics hold as investors focus on after-inflation returns. In the 1970s, for example, a combination of high inflation and high nominal capital gains tax rates led to very high discount ratios and very low price-earnings ratios.
Second, the global economy is changing because it increasingly relies on intangible capital and less on tangible capital. When a company acquires a new tangible asset, like a new factory, it depreciates the asset over its useful life. On the other hand, intangible investments such as research and development or advertising can be expensed immediately.
As the author noted, “So it’s the form of investment, not just the magnitude of investment, that dictates the earnings a company reports.” He added that companies relying on intangible capital have fewer assets on their balance sheets, so they display higher returns on capital.
Mauboussin’s third driver of unstable populations behind price-earnings ratios was the equity-risk premium. He wrote, “In periods of general optimism, equity-risk premiums shrink, and premiums expand when investors are cautious. The ebb and flow of investor risk appetite likely contributes to the nonstationarity of multiples.”
Despite all the talk about changes in populations undermining price-earnings usefulness, it’s been pointed out that the ratio has averaged slightly more than 14 over the past 130 years. Mauboussin rhetorically asks, “Isn’t this proof enough that fourteen is the multiple to which the market reverts?”
His rhetorical answer was a qualified no. That’s because two of the three drivers of instability, taxes/inflation and the equity-risk premium, are likely bounded. In other words, they go back and forth within wide channels, but rarely break out of them. As a result, the zig-zags could be canceling each other out over the longer term.
Regarding the other driver, greater capital investment in intangible assets, its likely to be pushing up price-earnings multiples. That’s due primarily to the existing accounting system, which allows intangible-heavy companies to expense their investments. At the same time, though, the author noted that the period of sustainable competitive advantages for intangible-heavy companies may be shorter than it was for companies that relied on tangible investments.
Mauboussin wound up the chapter by urging investors to use price-earnings ratios sparingly and cautiously. More specifically, he meant that investors will get more value out of the ratios if they understand the assumptions embedded within them.
Conclusion
Price-earnings ratios have been near the tops of investors’ toolboxes for many years. Michael Mauboussin urged us to look beyond the price-earnings numbers to try to find out what underpins them.
It’s quite possible that there’s been significant churning below the surface, making historical price-earnings ratios less reliable than we might have thought. As noted, there are three primary drivers behind the churning: taxes inflation, tangible/intangible capitalization and the equity-risk premium.
As with all investment tools, we should carefully consider the price-earnings ratio when using it for critical valuations.
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