If there's one financial ratio that is quoted more than any other, it has to be the price-earnings ratio. In its simplest possible form, the price-earnings multiple is the ratio of the company's share price to earnings per share. It provides a rough guide as to how many years investors would have to hold the stock to earn their money back.
The price-earnings ratio has become the go-to financial metric for so many investors and individuals over the past 100 years because it is so simple. Every company highlights its earnings per share figures in quarterly results and annual reports.
It's relatively straightforward to take this figure and divided it by the current share price. And with so many people making use of this straightforward ratio, it became the benchmark. It is easy to see if a company is more expensive than the rest of the market and other companies in its sector by using the price-earnings ratio as the figure is so widely used.
But the simplicity of this ratio suggests it's becoming increasingly out of date.
A look back at the price-earnings ratio
When Benjamin Graham was teaching his students about fundamental investing 100 years ago, the world was a very different place. Businesses were incredibly capital-intensive. A company needed capital assets to produce profits.
Therefore, it was easy to look at the company's capital assets and place a value on the potential output they could produce compared to the investment required. Metrics like the price-earnings and price-book ratio were good enough to evaluate a company's assets and productive asset base because there was a limited number of inputs and outputs.
However, over the past few decades, this has changed. Price-earnings ratios only take into account a company's financials. As the world has become increasingly driven by brand power and intangible assets, a company's financial earnings power has become less and less critical. At the same time, earnings multiples have always been overly simplistic. They only provide insight into a company's income statement, which is helpful up to a point. Cash flows are far more critical.
A business that does not generate cash is not going to last long. At the same time, a business that generates lots of cash but does not earn a profit could be a hidden gem. The price-earnings ratio has never been good at identifying these types of businesses and it never will be.
The main drawback of the price-earnings ratio is the fact that it's so simple. It can be helpful when analyzing some businesses, but it's becoming less and less relevant. It should only ever be used as part of a valuation tool kit, and its use should be limited.
A business owner's perspective
The benefits and drawbacks of the ration can be much better understood from a business owner's perspective. If I run a business, I will never think about its worth based on some arbitrary multiple of earnings. This is irrelevant because it does not take into account quantitative factors such as my level of experience and relationships with customers I have built up over the years.
I am also well aware that financial figures can be manipulated, so what really matters is how much cash a business is making, not just quarterly but throughout the year. I'm also going to be considering things like cash reserves, potential tax liabilities, starting problems and client relationships if and when a business is sold or acquired.
Put simply, an overreliance on the price-earnings ratio can be downright dangerous. It's a useful valuation tool when used as part of a tool kit, but it should never be relied upon as a standalone metric.
Read more here:
- How to Analyze Stock Buybacks According to Warren Buffett
- Charlie Munger: The Factors to Consider When Valuing a Business
- 3 Benjamin Graham Style Net Net Stocks
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