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.