The problem with the simple PE ratio or should I say the problem that some value investors have with the simple PE Ratio is what I am about to describe in a little example below. Say a company is currently trading at a PE ratio of 10 times. And the earnings per share for the last 12 months is $1. Hence, the price of the company should currently by 10 x $1 = $10
Isn’t that right?
Now you could make the argument that if the earnings of the company is projected to grow by 50% next year, one could apply the same P/E multiple to $1.50 per share instead and predict that the price of the company should trade at 10 x $1.50 = $15 next year.
Wrong!
Now you are going to find out how extremely unreliable that heuristic is when it comes to valuing a company’s business. Let us have a look at Amazon and its PE multiple history over the years.
Source: Morningstar
Now, examine the the price to earnings history. It was as low as 34 in 2008 and as high as 1429 in 2013. In its more recent years, the PE multiple traded at around 170 to 180. The variability and the range of the PE multiples of Amazon was really in a sense the norm of things.
Price To Earnings Multiples Can Be Very Volatile + Earnings Can Vary Dramatically
And this brings me to my point. The PE ratio is not the most reliable way to value a company. And the other thing is that the PE ratio, as is the norm in many cases, just has a way of varying itself. Benjamin Graham in a way spoke about this as Mr Market, the manic depressive. Sometimes, the market values the company at a high price to earnings and sometimes a low one. This is to be expected of the market.
Now, besides just using a simple PE ratio for valuation, one could complement that with the relative valuation techniques and/or the discounted cash flow methodology. There are after all several vantage points to valuing a company. If you were to talk to professor Aswath Damodaran, he would of course advocate DCF as a means of ascertaining the value of a company.
However, these valuation techniques are laden with subjectivity rather than objectivity. What I prefer best is to value a company based on its assets, more specifically, the tangible assets. That is one of the reasons why Ben Graham loved the net current asset value approach. It is first principles thinking in the form of “what is” rather than “what will be”. What is happens to be very different to what will be. What is relies on truth, a fundamental truth while what will be relies on some speculation on the part of the investor, unless the investor really understands the business. Elon Musk has this to say about first principles thinking.
Well, I do think there’s a good framework for thinking. It is physics. You know, the sort of first principles reasoning. Generally I think there are — what I mean by that is, boil things down to their fundamental truths and reason up from there, as opposed to reasoning by analogy.
Through most of our life, we get through life by reasoning by analogy, which essentially means copying what other people do with slight variations.
~ Elon Musk
To me that is as clear as daylight. Talk about stepping over 1 foot hurdles. Those are mine. Hence, my preference is an asset based approach first before looking towards other metrics.
Thank you for reading! May you be blessed with prosperity, health and happiness!
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These books which I have written are case study driven and discuss strategies, mindsets and situational approaches to employing the net current asset value strategy.
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- A database of net net stocks or net current asset value stocks
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