Don’t overanalyse PE multiple; understand business, growth levers

There is a raging debate these days on the price to earnings (PE) multiple. This debate is as old as the stock market and keeps cropping up typically when markets have been running at a high PE for a few years.

My thoughts on the PE debate is that it is a waste of time.

First, let’s put an objective and quantitative hat and attack this problem. What is high PE? Is 15 high? Is 25 high? Is 50 high? Or is 100 high? No one answers this question. We cannot have a debate where what one is debating on is a vague notion.

Second, let’s look at what PE is. In absolutely layman terms, PE is the multiple of earnings one pays to buy a stock. Every asset value can be broken up into two parts—i) intrinsic value, which is derived from its tentative future cashflows and ii) transaction value, which is derived from what value someone else will pay for it in a transaction. For example, a painting or a flower vase has no intrinsic value, but it has a transaction value based on what another person is willing to pay for it. As a brief aside here, this is what is happening in something like Bitcoin today. It has no intrinsic value. Its entire value is derived from the transaction value.

Where investing becomes challenging is, both the intrinsic value and transaction value cannot be reliably estimated for the future. A discounted cash flow method is one of the well-known and practised methods of calculating intrinsic value. This method also needs a large number of estimates and guesses. You need to forecast future cash flows, possible capex, discount rate, terminal growth rate etc. Any major deviations in any of these make the entire DCF exercise near about meaningless. What DCF as a practice is good for, if done well, is it helps in thinking through different scenarios and look at different levers that impact the cash flow of the business. You can get a rough idea of a range in which the intrinsic value could be.

The transaction value, on the other hand, is purely a function of demand and supply. So, if you think a Da Vinci painting (or Bitcoin or a piece of rock, whatever) will have higher demand tomorrow than supply, and more people will be willing to pay more than what they are willing to pay today, then the transaction value goes up. Sometimes the transaction value depends on the factors that influence intrinsic value as well. If there is a general consensus that a company is likely to do well in the future even though they may not have done well in the recent past, the stock price does not suffer, as the transaction value compensates for the fall in intrinsic value.

In PE as in real-life asset prices, both these components are present implicitly. Two stocks with the same earnings may have completely different PEs. That is because both their intrinsic value and transaction values could be different. We see this phenomenon play out in the private equity market. Companies with no current earnings get a high PE, because either there is an expectation of higher future earnings or there is an expectation that its stock will have higher demand than supply in the future.

One way to practically use the PE ratio, which I personally use, is to look at the relative PE. It is clear from history that some companies which have better governance, management, growth etc are always valued higher (that is, their transaction value is higher) relative to others. So, a way to quantify this is to look at a company’s PE to the index PE. If you do this exercise, what you do is you take away the exuberance of a bull market and the despondence of a bear market and normalise the PE ratio.

Another important point to understand is that PE is not a valuation metric that should be relied on solely for decision-making. One reason why it is so popular is that it is easily available and everybody can use it, even if they do not understand anything about the business.

My personal experience is that if, as an investor, you focus on understanding the business and its growth levers and leave the academic debates to others, you will probably do much better than if you focus on the PE debate and waste your time.

—Abhishek Basumallick is a full-time investor and writes at intelsense.in. The views expressed in the article are his personal. 

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