P/E and P/S ratios are simple valuation tools. Yet many investors use them wrongly and lose money in the stock market.
An investor I met recently bemoaned that valuation was a rather meaningless tool in stock investing. His experience buying cheap stocks – as defined by a low price-to-earnings or price-to-book ratio – had not been profitable.
I shared that my experiences were similar.
In my earlier days, when starting research on a company, valuation metrics like P/E or P/B were one of the first things I looked up on Google Finance or Yahoo Finance.
If its P/E was low enough, I would then proceed to read up on the company. If it was high or “NA” (meaning still unprofitable), that would be the end of my interest.
As a result, my universe of investable stocks contained only low P/E or low P/B stocks.
Yet my experience investing in cheap companies had not been great.
I soon found that cheap companies could remain cheap for many years, resulting in huge opportunity costs. Worse still, cheap company trading at 9x P/E or 0.5x P/B could easily end up trading at 6x P/E or 0.3x P/B, resulting in huge losses.
My observation is the world of value investing focuses too much on valuation. Even NYU’s Stern School of Business has a Professor of Finance (Aswath Damodaran) revered globally as “The Dean of Valuation”. No Dean of Finance, no Dean of Investing, but Dean of Valuation.
In my opinion, this preoccupation with valuation and cheap stocks presents a few issues in investing.
First, investors are using a single number to dictate whether it is worth spending more time researching a company or whether to invest in a company.
In reality, investing is more complicated and more multi-faceted.
For me, there are more important factors in determining whether a company is a good one or one worth investing in. These other factors include the business model, growth rates, quality of management, etc.
Second, the focus on cheap stocks usually means restricting oneself to low quality companies or companies with underlying issues. There is a reason why these companies are trading at low valuation multiples to begin with.
This invariably excludes many companies that are of a high quality and performing well fundamentally. Such companies almost never trade at low P/E but have proven to be profitable investments over the years.
Third, valuation metrics on many finance websites are quoted on a trailing basis. Using the Price-Earnings ratio as an example, this means that earnings of the past year is used in the denominator.
Investing is about assessing the future prospects of a company; using historical earnings tells us almost nothing about the company going forward. Yet investors continue to rely on trailing metrics as useful data in their assessment.
With these issues in mind, how can investors use valuation in a more useful and profitable manner?
1. A Different Approach
In my opinion, a better approach would be to first focus on factors that are far more important than valuation. Factors such as competitive advantages, growth prospects and management quality instruct the investor on the quality of the company.
Valuation can subsequently be used as a tool to time entry and exit in a position.
Even then, investors should be cognizant that valuation is ultimately a tool with subjective assumptions and is a very rough gauge of value.
Stocks that are seemingly cheap can get much cheaper and stay cheap for a long time. Similarly, stocks that are seemingly expensive can get even more expensive and stay expensive for years.
Personally, valuation now has a lower weight in my stock analysis than it used to. Quality of the business, strength of the balance sheet and quality of management far outweigh valuation in my book.
If I like a company that may be trading at a seemingly high valuation, I may still take a small stake in the company.
2. A Catalyst
A cheap valuation alone is not a condition for the stock price to rise.
In my experience, investing in cheap companies is most rewarding when there is a catalyst that increases the value of the company. Examples of catalysts include a new and successful business line, a change in the demand for the company’s products, or a buyout that values the company at a higher price.
A good example is the recent explosion in share price for Super Micro Computer (SMCI).
I first invested in SMCI in the middle of 2023. My valuation work showed me that the company was trading with forward P/E in the low teens.
For a year, the market gave no credence to the company’s low P/E even though it had been performing well fundamentally and had guided for impending strong growth. The share price remained flat for much of 2023.
In Jan 2024, when the company reported strong revenue growth and guided for even stronger growth in the near future (i.e. a catalyst was present), its share price surged from under $300 to over $1200 in 2 months.
3. Forward P/E
Earlier, I discussed the downside in using trailing P/E. I have found forward P/E to be a far more useful tool. This involves using future earnings of a company in the denominator when calculating the P/E ratio.
Using future earnings requires analysts to make assumptions about the company’s future performance. It allows analysts to incorporate their views about the company’s growth rate, profit margins, etc.
While these views may not eventually be accurate, being directionally correct will result in a more comprehensive valuation exercise that is far more useful to the investor.
Often times, I have come across companies that may look expensive on a trailing P/E basis but are cheap on a forward P/E basis. This is because the company may be about to experience massive growth or may be at an inflexion point in profitability.
To illustrate, say we have a company trading with a trailing P/E of 80x and currently has 2% net profit margin. If its profit margin increases to 8% in 2 years’ time, all else being equal, this would result in a forward P/E of 20x because earnings have increased four-fold.
This dramatically changes the perceived valuation of the company.
A note on P/S
Valuation metrics using revenue (i.e. sales) in the denominator (such as the Price/Sales or Enterprise Value/Sales ratios) have become popular in recent years.
This is because there are now more listed companies with negative earnings. Without positive earnings, P/E cannot be calculated. As a result, P/S has become a popular tool to measure and compare the valuation of these unprofitable companies.
In my opinion, the P/S ratio should not be used.
The reason is because different companies have different cost structures. Company A may eventually have a 10% net profit margin when profitable while Company B a 20% net profit margin.
What useful information can the P/S tell us about the true value of these companies? Is it reasonable to make an apples-to-apples comparison of value using the P/S ratio? I think not.
A better approach would be to form a view of future earnings, say 3-5 years down the road, calculate the forward P/E, and then make a more informed decision based on this forward P/E.
If one does not expect the company to reach profitability within the next 3-5 years, then perhaps the company is not worthy of inclusion in one's portfolio.
Conclusion
Investors place too much emphasis on valuation when analysing companies. Valuation, while useful at times, has its limitations.
To be a better investor, investors should focus on other factors such as quality of business, growth prospects, strength of balance sheet, etc. In addition, a catalyst is often required to invest profitably in cheap companies. Finally, using forward earnings in the P/E ratio would be far more useful to the investor.
If you enjoyed this
and believe I can help you in your investing goals, I can be contacted at cedric.ho@madpartnership.com
Sign up for future newsletters at https://www.madpartnership.com/resources
Comments