The Fountain of Youth, the City of Gold, Shangri-La, a simple tool for finding winning investments — all have been sought by those that would escape the daily struggle and secure a life of comfort. Unfortunately (or perhaps fortunately for you optimists out there) they are yet to be found, though plenty of explorers have been lost uncovering what turned out to be mirages.
The price-to-earnings ratio, often referred to as the P/E ratio, is one such mirage. A simple enough metric used by many investors — professionals and part-time share jockeys alike — to determine whether a share is cheap. As with most simple answers to complex problems, the P/E ratio leaves much to be desired in its ability to unearth shares that will guarantee riches.
Keep it simple
The P/E ratio is a simplified version of the discounted cash flow (DCF) method. The DCF method attempts to calculate the value of all future cash flows from an investment — the definitional value of that investment — in order to arrive at a price you would be willing to pay for that investment.
To achieve this, an investor must attempt to forecast the cash flows a business will generate from now into infinity. Not only is infinity a long time, but forecasting cash flows requires making several difficult assumptions. The potential total demand for the company's product, the ability of management to fend off competition while maintaining efficient operations, the success of new product development, and the impact of exchange rates and government regulations are just a few examples.
Know what you're measuring
The P/E ratio simplifies this by attempting to value a share by substituting earnings for cash flow to measure how long it will take for the company's earnings — the "E" in the ratio — to pay back the initial investment — the "P."
If a share trades at $1 with a P/E of 10 the market is willing to pay 10 times the current earnings – 10cents in this example — for those shares. Whether or not those shares are cheap depends on if you think that offers you a good return on your $1.
Of course in determining whether you think it is a good return requires you to make assumptions similar to those outlined in the DCF discussion above — even if you don't realise it. Of course if you don't realise these are the assumptions you are making, it raises questions about how accurately a P/E ratio values a share.
It should also be noted that thanks to various rules of accounting, earnings rarely equal actual cash flows. The table below shows the reported net income and operating cash flow — the actual cash received or used by a company's operations in a given period — from a few ASX listed companies.
| Last Annual Report |
Net Income ($m) |
Operating Cash Flow ($m) |
P / E Ratio |
| Qantas Limited (ASX: QAN) |
248.0 |
1,782.0 |
14.8 |
| Amcor Limited (ASX: AMC) |
356.7 |
785.8 |
26 |
| David Jones Limited (ASX: DJS) |
168.1 |
182.4 |
6.8 |
| Aristocrat Leisure Limited (ASX: ALL) |
66.1 |
108.2 |
25.7 |
| Codan Limited (ASX: CDA) |
21.8 |
26.4 |
10.2 |
| Cash Converters Limited (ASX: CCV) |
27.6 |
14.8 |
8.6 |
| 1300 Smiles Limited (ASX: ONT) |
5.14 |
6.3 |
20.2 |
Source: Company Reports
As you can see, there can be quite a discrepancy between reported earnings and operating cash flow (which doesn't even account for the maintenance spending necessary to keep things up and running — reducing the cash available to shareholders), so using a price to earnings ratio to value a company could result in misleading conclusions.
Two sides of the story
Investors should also realise that each component of the price-to-earnings ratio — share price and earnings — is dynamic. Returns won't just be determined by the market re-rating a share with a low P/E, they will also be determined by the growth — or decline — in earnings over time.
A company with earnings of $1 per share trading at a P/E of 7 may look like a bargain at first glance, but if earnings (or more importantly cash flows) decline over the next three years at an average of 5% per year, the P/E will rise to 8 if the share price remains steady, but not for the reasons an investor would like. Of course with that type of earnings performance, I doubt the market would leave the share price untouched, and an investor would likely see their bargain share price get even cheaper.
On the other hand, a P/E of 20 might put off investors, but if that company is reasonably capable of growing its cash flows at 15% per year over the next five years, I would consider it an attractive investment.
P all and End all
The lesson, as always, is there are no shortcuts to great investing. No single number can illuminate the shares that will provide you with a comfortable retirement. Investors can use tools like P/E ratios as guideposts, but to find truly great investments requires digging into the numbers and getting to know a company, its management, and its industry.
If you are looking for ASX investing ideas, look no further than "The Motley Fool's Top Stock for 2012." In this free report, Investment Analyst Dean Morel names his top pick for 2012…and beyond. Click here now to find out the name of this small but growing telecommunications company. But hurry – the report is free for only a limited period of time.
More reading
Motley Fool contributor Mike King doesn't own shares in any of the companies mentioned. The Motley Fool's purpose is to help the world invest, better. Take Stock is The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it's still available. This article contains general investment advice only (under AFSL 400691).
A version of this article, written by Nate Weisshaar, was originally published on fool.co.uk
