Source: http://musingzebra.com/whats-wrong-with-p-e-ratio/

Price to Earnings ratio is the most widely used tool to gauge the attractiveness of a stock. But it is important to know the limitation of PE ratio so we don’t fall for the “everything looks like a nail to a man with a hammer” illusion. Here are a few things to understand. 

Confuse between “most low P/E stocks are cheap” and “most cheap stocks have low P/E”

A classic misconception is we assume low PE stocks are generally cheap. Just as “most rich people are Asians” is not the same as “most Asians are rich people”, most cheap stocks have low PE simply means out of all the stocks that are truly cheap, a majority of them have a low PE, while the rest are in high PE. It is different from saying most low PE stocks are cheap because stocks that are cheap and have low PE might be 10 out of every 100 low PE stocks. This confusion causes us to overestimate our chance of finding cheap stocks in the low PE universe. 

PE is relative, not absolute

When we talk about a stock is cheap, or expensive, it is a comparison between the PE (or share price) and the value of the business. Just as knowing that I run 5km has little meaning without knowing how long it took me to complete it, a stock with a P/E of 5 or 8 has little meaning by itself without knowing how much future value the business can potentially generate. The two drivers that determine the value of a business are the capital return and growth rate. In Exhibit 6, Michael Mauboussin shows how 3 companies with different growth rate and incremental return can command the same PE. As an example, a company can be cheap at PE 30 if it can generate $20 on a $100 dollar capital (high capital return) for a long time (high growth) while another company that fails to cover its cost of capital can be too expensive even at a PE of 5!

Growth can be bad

Lionel Robbins, a British economist, describe economics as “the study of the use of scarce resources which have alternative uses.” All businesses have an invisible cost imposed on them due to the scarcity of resources. Think of this cost as the minimum amount a company must earn to compensate for the risk of running the business. Also called the cost of capital or opportunity cost, this cost is affected by interest rates, but as a rule of thumb, an 8-10% return on capital is a good benchmark. So if you have a business that generates 5% return on capital every year, you would rather sell the business and allocate the capital for alternative uses that either generate a similar return at a way lower risk (think term deposits) or ones with a higher return at the same risk. Such as another attractive business or the property market. 

Growth, again, has little meaning without any reference to the future return of the business. Growth is only good if it is above the cost of capital. Most stocks have permanently low PE not because they are cheap, but simply because they’re destroying shareholders value by failing to cover their cost of capital. Here, growth has an opposite effect on PE—faster growth lead to lower and lower PE.  

Higher earning doesn’t mean higher P/E

We get this all the time. If earning grows, the stock deserves a higher PE. This makes sense intuitively because if the business is making more money, it should be more valuable, hence a higher market expectation should translate into higher PE. But that’s not always true. If I have a fixed deposit account that earns 3% per annum and reinvests everything on year-end, the account would have grown 15.9% over 5 years. Does that mean it is more valuable now and the bank deserve a pat on the back for doing a good job? No. The return is still 3%. It grows because of reinvestment, not because of adding more value. Similarly, a company can ‘grow’ and become fat simply by retaining all their earnings without paying any dividend, but it certainly doesn’t deserve a higher PE. 

The market is long-term focused

If you ever wonder why unprofitable companies (think Uber) can have rich market valuation while other companies with decent earnings have a permanently low P/E, the reason is because the market is always assessing the prospects of a business in 15, 20 years time and translate those future earnings into what it should worth right now. Therefore, a temporary growth spurt on quarterly earnings doesn’t necessarily mean a low PE stock suddenly becomes cheap and deserve a higher valuation unless there is a positive change in market sentiment. 

Certainty illusion

Valuing a stock using PE multiples is similar to using the quote “Be greedy when others are fearful”, you need to understand the true meaning behind it. Just as the quote can be used to rationalize any buying decision, you can use PE to value any stock. But are you really doing a valuation? PE multiples can create a certainty illusion that we think we know how to value a stock when we don’t know what we are valuing. Most of us know how to use PE, but very few understand how to use it. 

Compound matters

If you fold a piece of paper in half for 50 times, how thick will it become? The height of your knee? A single story? Not quite. The thickness will be more than halfway over the distance towards the Sun, or 112 million km to be exact. Most things follow a power law in scaling. The same law governs compounding as well. We tend to think if a stock that generates 15 cents on a dollar (15% ROC) deserve a PE of 15, then one that earns 30 cents on a dollar (30% ROC) should deserve a PE double of that, or 30x. But that ignores the power of compounding. A stock that can compound at 30% for a long period of time will enjoy a growth that follows a power law and can easily worth a PE of 60 or 70.

P/E Ratio is just an instrument

Investing is like flying a plane, you need to constantly monitor many instruments from the altimeter, airspeed to fuel gauge and attitude in order to get to your destination safely. PE is a crude instrument that is very inaccurate, like trying to determine who is going to win the Oscar by watching a 30 seconds movie trailer. You have to put PE into the context by looking at other things like the characteristics of the business, industry, capital structure and so on. Looking at PE alone is like staring at the fuel gauge all the time. While it is great to know you still have enough fuel to fly, you might be flying towards the ground, or heading in an opposite direction to where you want to go. PE is just an instrument. Before you use an instrument, make sure you know the limits of it.