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Income Statement Analysis
- Great companies and good
EPS growth
do not guarantee
stock market profits
- The P/E ratio can create
buying opportunities
- Mishaps can create steals
- Unusual charges reduce the
value of your stock
- ROE is the single best tool
for investors
- ROA is another valuable tool
- Investors pay for high profit
margins
- Lenders can eat up all the
profits
- Depreciation creates
deferred taxes, which have
equity-like qualities
- EPS is a complicated
calculation
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The P/E ratio can create buying
opportunities
The price earnings ratio (“P/E ratio”) is the
multiple of EPS that a stock sells for. It is calculated by dividing the
share price by the annual earnings per share (“EPS”) of a company.
The P/E ratio is, by far, the most widely used
valuation tool in stock investing. There are, however, nuances that should
be understood when evaluating P/E ratios. The biggest drawback in using the
P/E ratio is that it ignores the balance sheet, cash flow, and business
cycle of a company. Below is a discussion of these drawbacks:
·
The Balance Sheet – While the quality and financial
management of the balance sheet is vitally important to the overall returns
of an organization, it is ignored by the P/E ratio. Leveraged, highly
indebted companies, must eventually pay back their lenders. Therefore,
profits and other financial resources, which would have been used to
increase shareholders’ value, are instead going to the lenders to pay back
debt. All things being equal, companies with less debt have more
opportunities to increase shareholder wealth, than companies with more debt.
The P/E ratio narrowly focuses on earnings and ignores the opportunity
potential of the balance sheet.
·
The Cash Flow Statement – Two companies with the same
EPS and stock price, can have significantly different cash flows, affecting the overall
long-term returns of these companies. Yet, again, the P/E ratio also ignores
cash flow. Ironically, it’s cash flow that builds wealth, not accounting
income.
·
The Business Cycle – The P/E ratio also disregards a
company’s business cycle. The business cycle reflects the company’s earnings
fluctuations within long-term economic trends. Companies can have big swings
in earnings, depending on where they are in their business cycle. Coming out
of a slow down, as earnings ramp up, the P/E ratio is usually high;
conversely, going into a slow period, as the stock price drops, historical
earnings may still be high, resulting in a low P/E ratio. There is a timing
gap, for cyclical companies, between the direction of earnings and the P/E
ratio. P/E ratios, therefore, are lagging indicators on the direction of
earnings.
Additionally, there is an
inverse correlation between inflation, interest rates, and P/E ratios.
Computationally, the ratio compares historic EPS to
the current share price. Relying on the factual ratio can be misleading, if
there are current year changes in the company’s financial performance. In
such cases, Investors need to recalculate the ratio, using the current year
or subsequent year EPS, not the prior year results. EPS is also affected by
unusual and non-recurring P&L items. Updating and using proforma data adds
value to the P/E ratio and can give the investor a slight edge. Current
earnings estimates are readily available on the internet; Bloomberg.com and
Zacks.com are good sources.
Normally, the higher a company’s P/E ratio, the
greater its growth potential. The best use of the P/E ratio is in the
comparison of companies in the same industry. Comparing the P/E ratios of
different industries is also a valid approach, but can be somewhat tricky.
One should not, for example, compare the P/E ratio of a drug company with
that of a bank. First of all, drug companies have completely different
earnings models than those of banks. Secondly, banks should be valued based
on book values, not P/E ratios.
What is a fair P/E ratio? Value investors should
look for a company whose normalized P/E ratio is equal to or less than its
growth rate. Momentum players pay more. Everyone “chases the cheese”
differently. Nonetheless, always compare the company’s price earnings ratio
to its growth rate, to gauge the premium or discount you are paying or
receiving.
When analysts and newswriters use price-to-sales
ratios to determine value, watch out! This is a cue to avoid the stock; you
pay for earnings or cash flow, not for sales.
Further complicating the P/E ratio are the effects of
mergers and acquisitions. Recently, private equity firms have purchased a
significant portion of publicly traded equities. The reduced supply of
equities may result in a P/E expansion for the remaining companies.
The intricacies of the P/E ratio can hide the true
underlying earnings of a company, thus creating buying opportunities for the
astute investor.
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