Few things divide the investment community as much as valuations. This division is what drives markets and in the most classical sense the efficient discovery of a price for a security. That may be good in theory but human emotions are the real daily drivers of market prices, and most often do not represent the true value of any firm. These emotions lead to quirks in the value of ratios, often and unfortunately at times the sole determinant of investment decisions.
 The oldest and currently most questioned is the Price to Equity or “P/E” ratio. The P/E ratio, thrust into prominence during the 1930s by value investors Benjamin Graham and David Dodd, measures the amount of money investors are paying for a company's earnings. Typically, companies that post strong earnings growth enjoy richer stock prices and fatter P/E ratios than those that don't.
Consensus forecasts of forward estimate P/Es from Sri Lankan brokers look reasonable and have thus led them to publicly claim that the future looks alright. Although the market has rallied 600% in two years, they say, there is plenty of upside left. What is wrong with the P/E as a measure of future success? In short, the "e" can't be trusted. Earnings are estimates provided by broker analysis based on consensus views of the future. These currently may be too high given the ‘recency bias’ (humans overweigh recent experience and exponentially discount away past history when making estimates according to research at Stanford and Duke University). That is a problem because investors pay much more attention to earnings forecasts than to past results.
For investors trying to gauge the market's value, one alternative may be to discard price and earnings in favour of enterprise value and free cash flow.
Stock price is just one measure of a company's worth. Enterprise value also considers long- and short-term debt, preferred stock, minority interests—in essence a company's entire capital base. By factoring in debt figures, investors can get a better read on whether a company is using leverage to get its profit results.
Free cash flow, meanwhile, is a broader measure that takes earnings and adds depreciation and amortization while subtracting capital expenditures. It offers a sense of a company's ability to boost dividends, buy back shares or attract suitors.
For instance, a strategy of buying the 50 cheapest U.S. S&P 500 stocks based on the enterprise-value-to-free-cash-flow ratio has outperformed a similar strategy using forward P/Es by at least 2% since 1986, with less volatility.
Share prices are a reflection of future earnings. The more uncertain those earnings are, the lower the corresponding P/E should be. Thus the relatively mild P/Es of the ASPI may be masking inherent uncertainty about the growth of earnings. More worryingly, estimates aren’t scattered amongst various analysts covering the same company, pointing towards a momentum and herding mentality, a classic sign for a long term investor to exit a position.
The P/E is losing its appeal, as the local market is increasingly driven by both global economic conditions and local regulatory uncertainty in a range of industries, let alone the market itself. To some extent this is in keeping with historical patterns. P/E ratios often shrink in size and significance during periods of uncertainty as investors focus on broader economic themes.
P/E ratios fell sharply in the U.S. during the Depression of the 1930s and again after World War II, bottoming at 5.90 in 1949. They plunged again during the 1970s, touching 6.97 in 1974 and 6.68 in 1980. During those periods, global events sometimes took precedence over company-specific valuation considerations in the minds of investors.
There have been periods when the P/E ratio was much more in vogue. A century ago, the buying and selling of stocks was widely considered to be a form of gambling. P/E ratios came about as a way to quantify the true value of a company's shares.
The P/E ratio should not be the only gauge investors use to determine the sustainability of the domestic market. There are a host of qualitative issues that won’t be captured through any financial ratio, which requires judgement and analysis that is much more intuitive than quantitative. The ability to couple a solid analytical framework with a qualitatively overlay will differentiate winners from losers in the market over the next few years.
(Kajanga is an Investment Specialist based in Sydney, Australia. You can write to him at kajangak@gmail.com). |
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