A quick – and important – thought on P/E ratios

I am in the process of going back and carefully reading everything Buffett has to say about valuing assets.

If you have followed Buffett, you have probably read that he is not a big fan of P/E ratios. P/E ratios are a kind of shorthand. The problem is, that for all they may tell you about a business, there is a lot that they leave out, which brings me to my quick point.

When looking at a P/E ratio, train yourself to carefully look at how much capital was required to produce the “E” (earnings). This can tell you a lot about the quality of the earnings. A business producing $1 million of earnings utilizing $4 million in tangible assets is far different from a business producing $1 million of earnings that requires $9 million in tangible assets.

Both may have the same P/E. The P/E of the second business may even be lower, but that does not necessarily mean that it is cheaper.

Assume these are growth companies that you project to grow at 10% over the next ten years. From a GAAP perspective each business will generate about $17.5 million in “earnings” over the ensuing ten years, but there is a big difference in the economics of the two businesses. Assuming consistent returns on equity, the first business will require an additional $6 million of capital while the second business will require an additional $14 million.

All growth businesses are not created equal.

P/Es are a useful tool to make the first cut. But it is essential to go deeper and look at the amount of capital it took – and will take – to produce those earnings.

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11 thoughts on “A quick – and important – thought on P/E ratios

  1. Tom

    Good piece.. thus wouldn’t it be wise for enterprising investors to disregard P/E all together and go straight to use EV/EBIT or EV/EBITDA as their first filter?

    Reply
    1. Greg Speicher Post author

      You don’t need to disregard P/Es, just be aware of their limitations. They could still lead you to some good investments. Also look at EBIT/Tangible Capital Employed (Magic Formula) and EBIT/Enterprise Value (where EBIT = EBITDA – Maintenance CapEx).

      Reply
  2. Mike

    In Morningstar, where do you find earnings? Is it net income from operating activities?

    Buffett said he brought business for 2 to 3 times earnings. What does earnings mean and where do you get the figure from?

    Thanks.

    Reply
  3. Pingback: Greg Speicher on PE Ratios | Chasing Bruce Greenwald

  4. John

    Hi Greg,

    That’s Buffett emphasis on ROE, isn’t it?

    One thing that is still unclear to me is what discount rates Buffett uses in valuing businesses. While he doesn’t calculate DCF explicitly, he definitely thinks in terms of discount rate. That’s his “a bird in the hand is better than two birds in the bush, and sometimes two in the bush are better than one in the hand” analogy.

    Some of his writings imply he “used” just the treasury yield rate and managed the risks with margin of safety. But some of his writings imply he did factor in some “risk premiums”.

    I had some discussions with Geoff Gannon a while back on this topic. But I still don’t have a conclusive view myself. Do you have any insight in this?

    Reply
  5. Greg Speicher Post author

    Yes this is Buffett’s emphasis on ROE. It is important to draw out its implications and see how dramatically it can impact investment results.

    My take is that Buffett uses the the rate on long-term government bonds as his discount rate. He may adjust it upward to normalize the rate in times of unusually low rates (like now). This rate is kept constant to allow him to compare “the cheapness” of various assets. Buffett does not raise the discount rate to compensate for risk which he views as nonsense. He only values and invests in assets that meet a certain “certainty” threshold.

    Having said that, Buffett does have a minimum hurdle rate. I’ve seen him mention 10% in the past 10 years as the minimum and it was arguably much higher (15% or more) earlier in his career. The fact that he uses the rate on the long-term bond for comparison in no way precludes him from running a mental DCF to approximate his rate of return if can buy what he determines to be a given future free cash stream at $x today.

    Reply
    1. John

      Thanks Greg.

      My understanding is pretty much alone the same line you put it.

      But what puzzles me is: In what spirit does Buffett use a hurdle rate for if it’s not a way to compensate for risks?

      Why will he reject an investment just because the return is below, say, 10% when this is currently the best idea he has? i.e. this is currently the most attractive asset.

      Reply
  6. Andrew Schneck

    Greg, going through all your past posts (this is why I’m commenting so late). Great stuff.

    Here’s a thought experiment- for your example of $4MM in tangible assets, how do you figure out the right price to pay in equivalence of the $9MM in assets? Do you simply not buy the $9MM business because you don’t like the economics? Where do you draw the line?

    Perhaps try thinking of where you’d draw the line in the sand for returns on capital, and if they fall below, simply don’t buy. But, in comparing $4MM to perhaps a $6MM in tangible assets for example, what P/E (or other) ratios would you require such that you were indifferent as to the purchase of one or the other?

    I’ve been playing these thought experiments out a lot with valuation and have come to some interesting conclusions. Just would be curious on your thoughts. Comparing one company to another isn’t so tough, the difficulty is in deciding your valuation points and being consistent across different opportunities.

    Reply
  7. Andrew Schneck

    Such as an 8X FCF multiple for the $4MM in tangible assets and a 6.5X multiple for the $6MM in tangible assets.

    While not buying the $9MM asset company at all.

    Reply
  8. Greg Speicher Post author

    If it is a long-term holding, it will be hard for the business to generate a return in excess of its return on equity over the long-term. Having said that, a business earning only 10%-12% ROE can still be a good – and possibly great – investment, if you can buy it at a cheap enough price.

    Reply

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