P/E – Multiple

Should Professionals Invest in Equities Based on P/E Ratios?

Evaluating the Usefulness of P/E Ratios for Investment Decisions

Many investors rely on the Price-to-Earnings (P/E) ratio as a fundamental metric for evaluating stocks. The common belief is that if a stock’s P/E ratio is lower compared to its historical average, its competitors, or the industry average, the stock might be undervalued, indicating potential price appreciation. But is this always the case?

The Pros of Using P/E Ratios

The P/E ratio has its merits as it is grounded in key fundamental metrics that define an organization’s value: Return on Invested Capital (ROIC), Growth Rate, and Weighted Average Cost of Capital (WACC). For investors, it is less about the amount of dividends distributed and more about whether the company reinvests in positive Net Present Value (NPV) projects.

The Limitations and Influencing Factors of P/E Ratios

However, there are critical components influencing P/E ratios that, if ignored, can lead to misguided investment decisions:

1. Impact of Debt/Equity (D/E) Leverage:

• The P/E ratio is affected by the company’s leverage. ROIC, Growth Rate, and WACC determine the total value of an organization, not just the equity portion. An investor must consider not only the earnings per share but also the risk range of these earnings. High D/E ratios increase the amplitude of expected earnings volatility, demanding higher returns for higher risks, thus naturally leading to a lower P/E ratio.

1. Accounting Policies:

• Accounting practices, especially regarding depreciation and amortization (including branding, goodwill, and R&D), can distort the intrinsic value of a company. Savvy investors often pair the P/E ratio with the EV/EBITDA metric to enable an “apples-to-apples” comparison. This is illustrated in the diagram comparing competitors based on both P/E and EV/EBITDA ratios, highlighting potential pitfalls of selecting stocks based solely on a low P/E ratio.

1. Sensitivity to Growth Rate:

• The P/E ratio is highly sensitive to growth rates. Therefore, when comparing competitors, it is crucial to group those with similar growth rates. Comparing a high-growth competitor with a low-growth one using P/E ratios alone can be misleading, as a lower P/E ratio in the latter does not provide meaningful insights.

Conclusion

While the P/E ratio is a useful tool, professionals should consider additional factors and metrics to make informed investment decisions. Comparing companies with similar growth rates, accounting for leverage, and using complementary metrics like EV/EBITDA can provide a more comprehensive view of a company’s valuation and potential for future performance.

Source:
Value: The Four Cornerstones of Corporate Finance
by McKinsey & Company Inc., Tim Koller, Richard Dobbs, Bill Huyett