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By Brian Nelson, CFA

Executive Summary: We break down the key components of a price-to-earnings multiple and highlight some of the pitfalls investors may encounter by using it incorrectly in the valuation process.

What is the purpose of such an article? The P/E ratio is so simple, right? It is just the price of the stock divided by the annual net diluted earnings per share of the firm. And the forward P/E is merely the price of the stock divided by next year's annual net diluted earnings per share of the firm. The P/E is probably the most common measure to help investors compare how cheap or expensive a firm's shares are, as stock prices for lack of a better term are arbitrary. For example, firms like Warren Buffett's Berkshire Hathaway (NYSE:BRK.A), which has never split its stock, have traded as high as $140,000 per share, while other well-known companies like Sprint (NYSE:S) can trade for just a few bucks per share. Citigroup (NYSE:C) was once a penny stock before its 10-to-1 reverse split in 2011.

It's only when investors compare a firm's share price to its diluted earnings per share that they have any idea whether a company's shares are expensive (overvalued) or cheap (undervalued). The higher the P/E, the more expensive the company's stock - and vice-versa. This seems way too simple, so why would we (or better yet, how could we) devote a whole article to talking about such a basic financial concept. Well, the truth is that the P/E ratio is not as basic as you might think (and even some of the most seasoned investors don't understand what this powerful multiple means).

As followers of Valuentum know, the second pillar of our buying index and a key component of this article, considers a company's forward P/E ratio by comparing this measure to that of its industry peers to determine if the company is trading at a comparatively attractive valuation. If the P/E is lower than its peer median, an investor is paying less per unit of earnings than the median of its peer group. Investors are getting a good deal in this case, all else equal, right? Well, the problem is that companies are never equal, and even comparisons among firms that are in the same industry can be misleading. It is also inappropriate for investors to apply a firm's historical median (or average) price-to-earnings ratio to the same firm's future earnings stream. But why not? It's the same stock. Shouldn't it be relevant and applicable? Well, yes and no. First, it's great for investors to have an idea of what "multiple range" a company has traded at in the past - there's lots of value to this, and most relevant for cyclical firms (mainly industrials) that may, from a fundamental standpoint, exhibit similar (but not identical) patterns with respect to both earnings and their P/E through the course of each economy cycle: think Boeing (NYSE:BA) and the commercial aerospace cycle; Ford (NYSE:F) and consumer demand for auto sales; or United Continental (NYSE:UAL) with respect to premium air travel demand. But for less-cyclical firms (and even for cyclicals where structural industry dynamics have altered over time), investors are wrongly assuming that the forward outlook of the past (which determined the historical multiple) will be the same as the forward outlook of the present (which determines the current multiple). This, unfortunately, is never true.

So what is an investor to do? We know that it's imperfect to compare a firm's current or forward price-to-earnings ratio to its peers or even to the median or average of its peers. No two firms are identical. And it's even more imperfect to compare a firm's current or forward price-to-earnings ratio to its historical measure. Look at Apple's (NASDAQ:AAPL) outlook in 2002 versus its outlook in 2009 - a lot different, would you say? One wouldn't apply the same multiple to Apple in both years, or if you did, it would be for different reasons/underlying factors. Okay, you may then ask: why does Valuentum use a price-to-earnings ratio at all in our process? Good question. The answer rests in its simplicity. Some investors do not use a discounted cash-flow process to value equities, and therefore, there exists what we'd describe to be market forces (self-fulfilling) that make the price-to-earnings ratio a meaningful consideration.

In other words, if Portfolio Manager A likes a stock because its P/E ratio is trading at the lower end of its historical P/E valuation range or is trading at a discount to its peers' average P/E, she might buy it, and this buying pressure itself causes the stock to rise, therefore making the P/E in this form relevant. In other words, if other investors (especially the ones with deep pockets) are paying attention to it, you should, too. In fact, this idea hits at the heart of our process at Valuentum - striving to have a complete understanding of all market forces (investment philosophies) that drive stock prices, such that we can capitalize on them. For this reason, and this reason alone, we include a relative value assessment in our process, in general, and the P/E and PEG (price-earnings-to-growth) ratios, more specifically. And it is because of this all-encompassing view that we've become a leading provider of research for the financial advisor. (click here for more info)

So, with that said, how should we look at the P/E then? Valuentum followers know that we use a discounted cash-flow valuation process (the first pillar of our Valuentum Buying Index) to uncover the intrinsic worth of every company in our coverage universe. Okay, now you may ask: "Why do you use a free cash flow model when stock prices are driven by earnings? Didn't we just define the stock price as a function of its earnings and a P/E multiple (the share price divided by net diluted earnings per share is the P/E)?" Well, yes. But earnings are a component of cash flow, and evaluating future free cash flows has its benefits.

For starters, the variations between earnings and cash flow not only arise in working capital changes over time (and their influence on a firm's cash flow from operations), but also in the timing of the cost of replacing those assets that generate earnings (capital expenditures versus depreciation). Plus, varying levels of interest rates paid on debt loads can also muddy the waters on earnings - not to mention that there are various ways to account for rent expense (whether to capitalize such assets or to allow the expense to flow through the operating line). So there are some major differences between assessing a company's value based on earnings versus based on using a discounted cash-flow model. And because earnings quality (are earnings being converted to cash flow?) and capital efficiency (how much capital needs to be plowed back into the firm to maintain earnings) are critical to assessing the health of a company and its valuation, using free cash offers a superior process.

But that's not all. And this gets at the core of the article. What many investors fail to understand is that the P/E multiple is precisely -- you guessed it -- a short-form discounted cash-flow model. So, in order to understand what multiple is appropriate to place on a firm's earnings stream (its diluted earnings per share) investors need to use a discounted cash flow process to do so. By calculating the present value of future enterprise free cash flows, adjusting for a firm's net balance sheet impact and making other adjustments (and then dividing by diluted shares outstanding), the investor arrives at equity value per share. Taking this equity value per share and dividing it by next year's earnings of the firm leaves you with - drum roll please - the price-to-earnings (P/E) ratio. And because a discounted cash-flow process captures the unique intricacies of the exact firm one is modeling at the exact time one is modeling it (and taking into consideration all future factors at the time), it is far superior to any relative peer or historical multiple analysis.

By now, you can probably see why we're such big fans of using a free cash flow model. Though there are many, many ways of looking at a stock-in fact, varying perspectives remain core to our process--using a free cash flow process is perhaps the only way investors can truly arrive at the "correct" intrinsic price-to-earnings multiple to place on a company's earnings.

Let's examine this even further. For example, have you ever wondered why capital-light companies (software, advertising companies) garner higher earnings multiples than capital-intensive companies (auto manufacturers)? Well, capital-intensive companies have to re-invest a significant amount of earnings back into their businesses, thereby reducing future free cash flow and, by extension, the multiple investors are willing to pay for that earnings stream. Remember from before that a P/E multiple is primarily driven by the discounted future free cash flows of a firm. Simply put, not all earnings streams are created equal - even given equivalent future expected growth trajectories in them. Investors should prefer the earnings stream in this case that requires the least amount of re-invested capital.

Okay … on to demystifying the price-to-earnings ratio. At this point, we hope that we have at least convinced you to be careful about arbitrarily placing a P/E multiple on a firm's next year's earnings to arrive at a target price (fair value). Even if that multiple is based on historical ranges (medians or averages) or is comparable to industry peers, investors fall short of capturing the uniqueness of a company's future cash flow stream via a discounted cash-flow process, which considers all of the qualitative factors of a company -- from a competitive assessment to the company's efficiency initiatives and beyond (yes, even management's strategy). Plus, using a discounted free cash flow model forces investors to think about the key valuation drivers of a company long into the future, thereby reinforcing forward-looking analysis and a critical understanding of what we'd describe as needle-moving inputs (revenue, WACC, etc.).

Without further explanation, here is our definition of the price-to-earnings ratio. You'll notice that it is forward-looking and considers many more components than just the future growth trajectory of earnings, which many pundits point to as the primary driver between the differences in two firms' P/E multiples:

Current Price to Earnings Ratio = {[(Sum of Discounted Future Enterprise Free Cash Flows - Total Debt - Preferred Stock + Total Cash)/Shares Outstanding]/ Current Earnings Per Share}

Upon further examination of the definition of the price-to-earnings ratio above, one can see that it is just a compressed, short-form discounted cash-flow model.

Below, we show how a number of qualitative factors influence the price-to-earnings multiple and whether they are positively or negatively correlated to it.

Revenue Growth: Impacts Future Enterprise Cash Flows (Mostly Positive)

Operating Earnings Growth: Impacts Future Enterprise Cash Flows (Positive)

Taxes: Impacts After-tax Earnings; Cost of Debt (Mostly Negative)

Capital Expenditures: Impacts Future Enterprise Cash Flows (Negative)

Return on Invested Capital (ROIC): Function of Operating Earnings and Net New Investment, Capital Expenditures (Positive)

Risk-free Rate: Impacts WACC (Negative)

Discount Rate (WACC): Impacts Present Value of Enterprise Cash Flows (Negative)

Total Debt: Impacts Enterprise Value and Discount Rate (Mostly Negative)

Preferred Stock: Impacts Enterprise Value and Discount Rate (Mostly Negative)

Total Cash: Impacts Enterprise Value (Positive)

Shares Outstanding: Changes in Shares Outstanding (Neutral, assuming reinvestments' ROIC equal the firm's WACC)

The key takeways are that 1) without using a discounted cash-flow model, the price-to-earnings ratio that should be applied to a company's earnings stream cannot really be appropriately solved, and by extension, 2) when investors assign an arbitrary price-to-earnings multiple to a company's earnings (based on historical trends or industry peers), they are essentially making estimates for all of the drivers behind a discounted cash-flow model in one fell swoop (and sometimes hastily).

As earnings for next year are often within sight and can be estimated with some confidence (though this certainly varies among firms), the price-to-earnings ratio, in our opinion, is of far greater importance in determining the true intrinsic worth of companies, requiring much more intricate and forward-looking thought. And because the price-to-earnings ratio is nothing more than a discounted cash-flow model, that's why cash-flow analysis is the first and most important pillar of our Valuentum Buying Index and the major consideration before we buy any firm for the market-beating portfolio held within our monthly Best Ideas Newsletter.

Source: Helping Financial Advisors Better Understand The P/E Ratio