The confusing PE ratio

[PaulWBryant]

Saul,

I asked a question on a thread the other day that I wanted to make sure you saw. You may just not want to answer, which is fine.

My reason for asking is that I really think I might be missing something. I know that some industries are inherently “riskier” than others. Your average tech company has a lot more risk of disruption than your average restaurant, for instance. Also, a huge company like Nike has less “risk” of sales falling than Skechers.

But sometimes it seems like the “risk” factor gets too much weight…and/or the growth factor is seemingly ignored. What I’m trying to get at below is, how have you seen this work itself out with smaller companies that continue their growth over time? Does the PE shrink until some inflection point where the stock gets bid up all at once? Or is it likely the PE on a stock like SKX may again someday shoot up into the 30s?

Just some thoughts and ponderings…feel free where to go wherever you want with this idea, if you do get a chance to share your thoughts. And thanks.

Here’s what I said:

PE’s can be a frustrating thing to me. Why is NFLX’s 300+ and LGIH’s is 11ish? LGIH is the faster-growing company. More risk? It’s practically a price difference of 30 to 1!

Why does a company that seems to be going nowhere, like KO, sport a PE close to 30?

SKX has gone down in price about 10% in the last few weeks…and I know the S&P has lost a few % points itself, but this just seems asinine to me. SKX just had an incredible quarter and has had a string of a bunch of incredible quarters and shows no sign of slowing down. Why do they have a PE around 17 – about the same or even slightly below the PE of SHOO – which hasn’t grown materially in years!?

I have always liked the quote (was it Keynes?) that goes: “The market can stay irrational longer than you can stay solvent.” So maybe I’m asking some questions that can’t be answered. But in your vast experience, Saul, what have you learned about how PE’s do or don’t get sorted out over time, in companies that keep growing and performing well every quarter? And how do you make sense of it in the meantime?

[PaulWBryant]

PS - others besides Saul are welcome to chime in too, of course. I will say quickly by way of clarification that I understand it’s nearly idle to compare NFLX to LGIH, or Google to MITK, or whatever. I’m just talking in general terms, so don’t scrutinize my examples too specifically.

[SaulR80683]

Okay Paul, I’ll take a stab at it. PE’s vary because:

1. Some industries have more glamor: NFLX certainly has more glamor than building houses. Anything regarding the Internet probably does.

2. Some companies are consumer facing: AMZN and NFLX are known to almost everyone, so they have larger PE’s than Skyworks, which is only known to someone in the industry, or LGIH, which is only known to a very very tiny proportion of the population. (You have to hear about the company before you’ll buy their stock).

3. Some companies are considered to be cyclical, like home builders or natural resource companies or companies tied to the business cycle. Other companies are expected to keep going no matter what. An inexpensive fast food chain, for instance.

4. Some companies are considered to be about fashion. I think that hits SKX, even though it’s wrong. That will correct itself with time, I suspect.

Maybe you can come up with some others.

Best,

Saul

[captainccs]

Not Saul!

I believe the P/E ratio is mainly the consequence of the expected growth rate of the stock. If a stock were as stagnant or as steady as a bond with the same risk characteristics it would have the same P/E ratio as the bond. The P/E ratio is the inverse of the yield. A bond paying 10% has P/E ratio of 10. A bond paying 5% has a P/E ratio of 20.

The way to value a bond is to calculate its yield to maturity. Say a bond with a par value of $100 due in six years is selling at $94 and paying a $5 each year, calculate its yield to maturity: You are going to get $5 each year and $100 at the end, your $94 plus $6 more.

Par value: $100
Market value: $94
Annual rate: 5%
Maturity in years : 6
Payment: annual
YTM: 6.23% (5% + 1.23%)
P/E: 16.05

The 1.23% is what you get for the growth from $94 to $100 in six years. If you could buy the bond at $85 the YTM would be 8.27% (5+ 3.27)

YTM Calculator:

http://www.investopedia.com/calculator/aoytm.aspx

As I have said often, growth tends to exhibit an “S” curve. As the stock becomes more popular the P/E ratio will expand creating the curve in the hockey stick at the bottom of the “S.” As the market gets saturated (AAPL) the P/E contracts as growth lessens creating the top of the “S.”

With bonds the calculation is straight forward. With stocks it’s by the seat of the pants.

Denny Schlesinger

[PaulWBryant]

Thanks, Saul. #2 especially is worth considering and makes a lot of sense. However, what could be more consumer-facing than Apple? And we know that its PE has contracted immensely. Maybe that’s due to fundamentals more than most “story” stocks, because the company really is taking a step back. But it’s interesting that it’s glamour and consumer-facing-ness haven’t propped it up any.

Some other possibilities for PE drivers:

5. Market Cap - Larger companies are seen as safer, so PE’s are higher. Even the stodgy WMT sports a PE of about 15, though some of that is due to the consumer-facing driver you mentioned. (Although again AAPL flies in the face of this)

6. Dividend Yield - Many investors put a premium on large dividends, so dividend stock PE’s will be higher.

But in the end it always seems to come down to 1) growth potential, 2) risk…and 3) irrationality.

Going back to the 6 non-growth drivers we identified so far, I think they all boil down to risk and irrationality.

1. Glamour basically encompasses a little irrationality and a little safety. Mostly the former, but one has to think that the perception of a Netflix or an Amazon is one of a foregone conclusion, not a risky “who knows how things will turn out?” I would even posit that in times where Netflix has been more seen as risky (Qwikster), the PE has gone down.

2. Definitely makes sense that the known is less risky than the unknown

3. Cyclical basically = risky

4. Fashion = risk

5. Big is generally less risky

6. Dividend preference is mostly irrationality if you ask me, but maybe a little bit of reduced risk. (ie, the company may go bankrupt, but until it does I’m getting my 3% yield each quarter)

The reason I am hashing all this out is that there are obviously other reasons besides growth potential that affect PE in a big way. If anyone can propose another besides risk and irrationality I’d be interested.

Also, I’m most interested in how these factors have been “sticky” (KO has always enjoyed a high-ish PE) or have changed or gone away over time (the “glamour” associated with TWTR has certainly eroded over the years), as these predict what we should expect in the future.

What I’m really saying is that when we consider a company’s PE, it might be worth at least a back-of-the-napkin attempt to tease out how much of it is due to growth potential, how much is due to risk, and how much is due to irrationality – either positive or negative. It seems like opportunity lies in finding stocks where the market doesn’t seem to be paying up for the company’s high growth potential, where more risk is perceived than actually exists, and the sentiment is irrationally negative…or at least not irrationally positive.

Bear

[LongNShort]

I’ll offer more:

• sometimes, the E is lower than it should because the money gets re-invested in growth (e.g. AMZN, NFLX). If the E is very small, almost any stock price results in a high PE.
• some investors use other yardsticks (and sometimes rightly so) - P/FCF, P/S, P/B
• durability (or lack thereof) of income streams. Compare the plausible future earnings power of Coke, P&G, maybe even KMI with e.g. Gilead. Their Hep C drugs Sovaldi and Harvoni rake in record sales right now but sales seems to peak right now. Competitors are coming in, insurers negotiate better prices, an increasing % of patients live in poorer countries with lower prices per pill. It is quite safe to assume that in 2-3 years Gilead’s sales and profit and E will be much lower than today. The stock price will hold up better (there are other, smaller, but more sustained income streams and an intrinsic value to the company). As a result, you will see business declining and P/E expanding

And sometimes, people don’t even know what the P/E is. Here is the P/E for Under Armour, all pulled at the same day within 10 minutes from different financial sites:

marketwatch       41.5
wallstreetjournal 41.5
Yahoo             42.7 
The Street        47.1
Fool              47.2
Fortune           47.2
Schwab            60
[finanzen.net](http://finanzen.net)      77.5
nasdaq            80.5
loomberg          82.9
money.cnn        170.6

To round things off, in a recent Fool article P/E was declared to be in the mid fifties. In reality, it is around 80.

bottom line: as important as P/E is, it is a quick and convenient but also quite limited way to value a company.

LNS

[tamhas]

Not to mention that it can make quite a difference with some companies if one uses the E from GAAP or the E from non-GAAP.

[PaulWBryant]

Thanks, LNS.

- sometimes, the E is lower than it should because the money gets re-invested in growth (e.g. AMZN, NFLX). If the E is very small, almost any stock price results in a high PE.

I’d file this under growth potential. If PE is “artificially” high because earnings are low due to reinvestment, another way of saying this is that PE is high due to the potential it will grow rapidly in the future (when reinvestment comes down a bit).

- some investors use other yardsticks (and sometimes rightly so) - P/FCF, P/S, P/B

True, but I think they’re all a way to approximate earnings potential. For instance, when I look at AMZN, I know they’re worth more than just some standard multiple of their current TTM earnings. How do I figure out what their likely future earnings will be? Go to revenue (P/S), or FCF, or whatever.

- durability (or lack thereof) of income streams.

File that under risk.

bottom line: as important as P/E is, it is a quick and convenient but also quite limited way to value a company.

As I said above, there are definitely plenty of things to consider, and as you’ve wisely pointed out, one of these is if the PE is being affected by short-term causes and appears artificially high or low. But I still say the main drivers come down to growth potential, risk, and irrationality.

[joegurguis]

I’m also not Saul! And I hope I don’t get banned from his board on my first post. I promise to post something useful right after this.

Just to wax a bit philosophical since I’m stuck in a hotel room and you brought it up …

I claim that on a gross scale the P/E range is calibrated to the length of human life expectancy. Doubling your money in 20 years (P/E = 20) allows one to potentially more than quadruple ones money during their lifetime, under the assumption that all profits are distributed back as dividends - which is attractive. This explains why, on average, P/E of 20 is typical and not 1000. If humans lived 100,000 years, a P/E of 1000 might be very attractive.

On a finer scale, and individual basis, this number is then adjusted by perceptions of risk, growth, history, and ultimately - DEMAND. The latter is important to grasp because demand is nonlinear. i.e. The fact that someone wants something can make me want it, rather than some quality inherent in the thing itself. And vice versa.

I do tend to see the market as often moving in discontinuous jumps. The analogy that comes to my mind is musical chairs. Once one person goes for a chair, there’s suddenly a mad rush of followers and a high demand for chairs.

One could say that the final P/E number is a time-dependent ensemble average of the perceptions and judgements of the millions of observers who participate in the ‘market’.

All of this is to say that while P/E is not completely arbitrary, it is certainly far from absolute or sacred.

Incidentally, I own a restaurant and our P/E is 3. SHAK last May commanded a P/E that made each of their restaurants worth 30x my restaurant for comparable sales. Each of their restaurants was valued at 50 million dollars. Apparently the perceptions of humans, even en masse, is subject to huge uncertainties. And even knowing the P/E was clearly absurd, I was still afraid to short it!