One of the most popular characteristics among value investors is that of investing in companies with a price to earnings ratio that is significantly lower than the market average. This ratio is commonly known as PER for short.
The measure can be interpreted in various ways. A share at PER 10 means that the market is paying an amount 10 times higher than the profits it generates. Therefore, and considering that the profit is updated every year, it would take 10 years to recoup the investment.
But why compare price with profit? Well, after all, the ultimate goal of the entrepreneur or investor who invests in a company’s capital, whether private or public, is no other than to participate in its profits. This is so because profit is what the business owner gets after deducting all the costs (operational, financial and tax-related) necessary to obtain the said profits. Therefore, if the price is what you pay and the profit is what you receive, it seems reasonable to start analysing an investment by comparing these two measures.
However, from the investor’s standpoint, this metric becomes more intuitive by changing the position of the components of the PER ratio, i.e. Profit/Price. In this way we automatically know the return obtained from our investment. Thus, if we invest in a share that has PER 12, we would be obtaining a return of 8.33% (1/12*100). Therefore, the lower the PER, the higher the profitability of our investment.
But what does a PER that is significantly less than the market average mean? Well, as in most cases, there is no exact mathematical formula to calculate the ideal PER at which a company should be listed. Although it may not seem like it, there is a great art to investing. Let’s say each share has its own ideal PER that fits the characteristics of the underlying business.
According to a study by Jeremy Siegel (1), in the last 200 years, American stocks have obtained a total real return (after inflation) of 6.6% annually. Therefore, it does not seem entirely rash to say that in the long term we are going to obtain a return quite similar to the latter in our investments. Thus, on average, a well-valued business should have a PER close to 15, since 1/15 * 100 = 6.6%. Starting from this base, this PER of 15 will have to be adjusted according to the characteristics of the business. In certain companies of exceptionally high quality, a higher PER of, for example, 20 could be paid. Similarly, a business with worse conditions will require a lower ratio.
The bottom line of stock investing is understanding that stock prices don’t always reflect the true value of their underlying business. This mismatch between value and price results in good businesses trading at low multiples in relation to their profits in certain situations.
Avoid unnecessary expectations
At this point, it is important to keep in mind that profit is an accounting entry from the past that can also be manipulated by company leaders. Therefore, for this ratio not to suffer distortions that may lead to misinterpretations, it is important to carry out a thorough prior analysis of the company’s accounting and its management team. It is certainly true that businesses by definition aim to be around in the long term and, therefore, cannot be valued as static entities. That is why the market value does not usually match the book value, since share prices will always try to assume the company has a future, as is logical. However, as we all well know, we cannot predict the future. Therefore, investors must put all the odds in their favour by trying to avoid unnecessary expectations.
In summary, let’s say that there are three options for the future of any business:
1. Profits may increase. If the profits of the business in which we are investing increase, in general, it is difficult for our investment not to be profitable. However, such profitability will be marked by the price at which we pay for those profits. Thus, the higher the price we pay, the lower the return.
2. Profits may remain constant. In this case, the PER will indicate the years we have left to recoup the investment. In this way, the lower the PER we buy, the sooner we will recoup our investment and the greater our return.
3. Profits may fall. Then it is most likely that we have made a mistake in the analysis and our investment will not generate value in the future.
As can be seen, if we buy shares with a high PER, we will only obtain good returns in the first case. Still, in cases where the company’s PER is excessively high, profit growth may not outweigh such prices (this is the case, for example, in some of today’s tech companies). However, if we buy companies with a significantly lower PER, we will be able to obtain profits in the first two scenarios. The odds are clearly in favour of cautious investors.
We have all been tempted to buy shares in one of those fantastic techs firms that keep growing. Investors expect so much from them that they are willing to pay exorbitant figures to participate in their profits. This gives rise to companies trading at PER ratios of 250-300, in which a future with exceptional growth in profits is being assumed.
Many investors have managed to make good returns by investing in this type of business. However, we will see that it is not the most recommended type of investment because, even if they are businesses with great competitive advantages, many of them will not be able to meet the high expectations for future growth.
Let’s consider a company with a PER of 250. If the best case scenario, mentioned above, was to occur, in which profits grew, for example, by 30% per year, in 10 years this company will have multiplied its profits by approximately 14 times (1.30^10 = 13.8). Considering today’s price, in 10 years the company would have a PER of 18.1 (250/13.8), which could be a reasonable price for a high-growth business. Once we’ve got to this point, 10 years later, we could expect a return of 5.5% per year (1/18), which would begin to be reasonable. However, before reaching the tenth year, the annual return on our investment would be practically insignificant. The question is: Do you need to wait 10 years to earn money?
Now suppose that the company’s profits did not eventually grow and remain at a constant level in the future. At the price we are buying today, it would take two and a half centuries to recoup the investment, with our expected return each year being approximately 0.4% (1/250*100). If the worst case scenario finally occurred, in which the company lost its profit level every year, there would be no other option but to try to dispose of the position as soon as possible.
In short, it may be prudent not to demand so much from our investments. Thirty percent annual growth in profits is a highly-demanding objective that the vast majority of businesses are not able to achieve. Sooner or later investors get tired of expectations and this may lead to large corrections in the prices of this type of stock. Therefore, a more conservative investment seems to be preferable in which, without sacrificing expected return, we increase the likelihood of success or, rather, we reduce the likelihood of error.
(1) Jeremy J. Siegel (1994). “Stocks for the Long Run”
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