Invest Wisdom

Hello attendees of the Carnival of Personal Finance at Weakonomics! Thanks for checking out my blog. The post below was the second in a four part series on value investing. The series started here, and continued here and here.

I really appreciate that you’ve come to check the series out. Subscribe here if you like what you see. And remember to check out today’s post which highlights five things investors should remember from Berkshire Hathaway’s annual shareholder meeting (the company Warren Buffett runs).

——

Yesterday, I wrote about the foundation of value investing and what value investors strive to do.

Today, I’m going to give a quick summary of value investors’ most popular tool, the Price-to-Earnings (i.e. P/E) ratio.

The P/E ratio is probably the most widely used measure of a stock’s value out there. I’d argue it’s also the most understood. I’ve read about investing strategies that rely on nothing but the P/E ratio to choose stocks. That doesn’t make sense, and I’ll do my best to explain why.

Calculating a price-to-earnings ratio is easy. You take the company’s current stock price and divide it by its earnings per share. Both of those can be found as popular websites, such as Yahoo! Finance, but most of the time, those same websites will simply give the P/E to you, already calculated.

The number that’s used for the earnings per share can vary between services. Most of the time, the default is to use the earnings from the trailing twelve months (TTM). But sometimes you’ll see a P/E based on estimated earnings for the forward 12 months or for the current fiscal year. All three of these kinds of P/Es are important. A service such as Morningstar will give you all three P/Es.

In effect, the P/E tells you what your money will yield, similar to the yield calculated for the hero sandwich shop in yesterday’s post. Except the ratio is inverted. To get the earnings yield, you divide the earnings per share by the price. The P/E is just the opposite.

Rather than take two mythical companies as we did yesterday, let’s look at an actual stock — Wal-Mart (WMT).

Go to the Morningstar page for Wal-Mart, click on “Valuation Ratios”, and you’ll get this page.

Wal-Mart’s price-to-earnings ratio, using trailing twelve month earnings, is 14.5. The retailing industry has a P/E of 15.8, and the market as a whole (represented by the S&P 500) has a P/E of 15.5.

I just threw a whole lot of numbers out there, but the basic premise is pretty easy. All else being equal, you want a company whose P/E is lower than that of its peers and that of the market. Wal-Mart’s stock meets both criteria.

If you look at Wal-Mart’s P/E based on estimated earnings (Click on the “Forward Valuation” tab), you’ll see a forward P/E of 12.5. This is even lower than its current P/E and means that analysts predict the stock’s earnings will go up this year.

——

Easy buy, right?

Well, the problem is the “all else being equal” part. Analysts regularly underestimate and overestimate earnings. What’s more, the P/E ratio doesn’t take into account any assets or debt that company has.

Take two companies. One has a P/E of 14, $100 million in cash on its balance sheet, and no debt. The other has a P/E of 14, $50 million in cash, and $400 million in debt. If you looked just at the P/E ratio, those companies would look equal. But take a look at the company’s balance sheet (where the assets and debts are recorded) and you’ll see a big difference.

Some investors try to take this discrepancy into account by subtracting cash from the share price or adding debt to the share price to calculate the true cost (known as “enterprise value”) of the company.

If you look at Wal-mart, for example, you’ll see that the company has $52.9 billion in “current” or liquid assets and $102.3 billion in total liabilities. (To find that, click on “Financial Statements” > “10-year balance sheet”) So its net liabilities are $49.4 billion. Divide that by the number of shares of Wal-Mart (about 3.9 billion) and you get net debt per share of about $12.61.

So while a share of Wal-Mart costs about $48.40, you’re actually taking on an extra $12.61 of debt, bringing the total per share price to $61.02.

Take $61.02 and divide by Wal-Mart’s per share earnings ($3.43) and you get an enterprise value/earnings ratio of 17.8. Doesn’t look as good now, right?

——

That’s just one of many reasons why a P/E is too blunt an instrument to use by itself in valuing companies. 17.8 seems like a high ratio, but Wal-Mart gets a premium for being a market leader in its industry and for having strong growth prospects in a recession. Unlike those of a company whose earnings are dropping (like an automaker), Wal-Mart’s earnings will probably grow over time. Investors know that. So they’re willing to pay a higher P/E for Wal-Mart.

In addition to looking at the P/E of companies in the traditional way, I’d recommend thinking of the P/E in an absolute sense. A company with a P/E of 10, for example, is giving you about a 10% yield for your money. That’s compared to guaranteed 2% to 4% yields in ultrasafe investments like CDs or money market accounts. When you see the 10% yield, tell yourself, “I could guarantee myself a 2% yield if I just stuck my money in a bank account. How confident am I that the company will be able to maintain or improve its earnings? And does the extra 8% yield pay for that additional risk?” If the answer is “very confident”, then the 10% yield is a very good deal.

A P/E of 10 in a company like Wal-Mart looks much better than a P/E of 10 in a company like GM. That’s what value investors mean when they say they look for companies with stable earnings, wide economic moats, and strong brands. What they’re really saying is just that they look for companies where they’re confident the earnings won’t erode.

Unfortunately, that kind of judgment is qualitative, not quantitative, and it separates brilliant investors like Warren Buffett from the also-rans.

You don’t have to be as adept as Buffett to find bargain companies. Most of the “secret” is simply to build in a margin of safety in case your estimates are off by a small (or sometimes wide) margin. I’ll address those qualitative measures in tomorrow’s post.

Thanks for reading.

- Joe Light