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The Trouble with P/E
Investment Strategy | 2 Comments | Tue 22 Feb 2011
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The humble price-to-earnings ratio (PE) has become the most widely referenced valuation metric amongst equity investment commentators. How useful is it as a valuation metric? Here we examine where the measure falls short and what the alternatives are.



Comments

1.
On 06/03/2011 10:42:20, Anonymous wrote:
Congratulations - a terrific article that highlights important issues most (professional) investors ignore.

I'd be interested in understanding a little bit more of the final sentence:
"Because we cannot credibly claim the skill to precisely forecast any of these, we should attempt to compensate for this uncertainty by being somewhat conservative in our analysis and by paying a price that is deemed low or, at most, fair for the investment."
The answer to this might be an article in itself, but what do you deem a low / fair price? Is it relative to other stocks, or other asset classes, or relative to cash? How do you deal with an environment such as today, where it could be argued that no asset class is particularly good value, versus say the early 80s where (in hindsight at least) all asset classes were good value?

Thanks.

2.
On 08/03/2011 09:41:29, VII wrote:
Thanks for the question. The answer, as you say, could be an article (or thesis) in itself. My answer depends really on your perspective. Some investors have a pre-determined requirement to be invested in certain asset classes. For example, an institution that is required to be invested in equities or bonds must evaluate the price of a given stock in the context of the valuation of the equities/bonds it is required to invest in. Presuming this is not the case for you and your investing mandate is unconstrained my answer is more convoluted.

Let me further presume that as a long-term investor your overriding aim is to preserve and grow the real, after-tax value of your capital. For you, comparing the valuation of one stock to another is not adequate. You should consider the investments available to you within your circle of competence. For starters I would advise you to steer well clear of investments outside of this sphere or you risk stacking the odds against yourself from the outset.

Let’s assume for the moment you are open to investments in stocks, bonds, cash and commodities such as gold. Comparing the valuation on offer for a given stock with the valuation levels in these asset classes is not at all straightforward because each has different characteristics. There is a lot of talk about gold and other commodities offering protection of real capital value. While I can see some merit here, I am not convinced. How does one value a non-yielding asset? Should we accept the notion that supply will always remain constrained? What if developments in mining technology facilitate a significant increase in supply of gold? Despite recent weakness, the yields on high-grade sovereign bonds are around record lows. Economic policies in place the word over seem the have the potential to be highly inflationary and as such these do not appear “risk-free” in the least. Short duration sovereign bonds should re-price if inflation spikes but again yield levels are very low versus history. As for cash, its short duration also provides some protection and as it is secure (in theory) it provides “optionailty” in the event of turmoil in financial markets (you can deploy the cash to buy cheaper assets). However on the minus side, we know that over the long-run cash loses real value and rates are, in most major currencies, close to zero. Perhaps more importantly, ask yourself the following question; how safe is my cash? In my opinion it is less safe than many believe. Your “cash” is primarily held in the form of loans that the bank has made to customers. Banks typically are highly illiquid, maintain wafer-thin equity capital and effectively exist only with the tacit support of the taxpayer. Depositors escaped losses in the most recent crisis, but may not be so fortunate the next time around.

I hope you can see that there are myriad considerations when comparing a stock with a commodity, cash, bonds or any other asset for that matter. This is even before we really get to discuss price. So what is a low or fair valuation for a stock in the context of a 0.5% deposit account, a 3% 10-year German Bund or an ounce of Gold for $1,400? There is no answer as such to this question. This is where we need to rely on our subjective judgement again. One way to think about this problem is to consider what earnings/cash yield the stock in question can provide us with on a steady-state basis. This is equivalent to Ben Graham’s earnings power. Then consider whether the company can preserve this in real terms. Let’s say you believe a quality business can provide a real free cash flow yield of 6.5% (a P/FCF of say 15), you should then consider whether you believe the company can enhance this through productive investment at a rate above the cost of capital or reduce this through destructive investment at rates below the cost of capital. If you believe this activity to be neutral then your best estimate is that the stock offers you a real prospective return of 6.5% p.a. Be realistic with yourself – you can’t forecast with any degree of accuracy so it might make sense to be willing to pay more for companies operating in businesses with good economics and with conservative management with a good attitude towards shareholder value. You should then consider how attractive this valuation is versus the 0.5% deposit account, the 3% Bund and the $1,400 ounce of gold, being mindful of the relevant risks involved with each. From then on it’s over to you. Stocks are risky but the default alternatives are risky too not least at current price levels. Furthermore don’t make the mistake of putting all of your eggs into too few baskets.

Any other opinions out there?

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