“Buy low P/E stocks. Mr. Market is giving you a bargain!”
At first glance, this reasoning is sound.
P/E tells you how much you are paying for every $1 of earnings the company generates. The lower the P/E, the cheaper.
At least that’s the theory.
In reality, buying stocks simply because their P/E is low can blow up your portfolio.
Here’s 3 reasons why.
1. P/E doesn’t account for debt
Imagine two companies.
Each holds $100 mn of assets.
They are exactly the same. Same assets. Same management. Same earnings.
The only difference: Company A financed $99 mn of its assets with borrowings. Company B does not use debt.
Which company is riskier?
Company A. Obviously.
If A is riskier, then it should follow that A’s earnings should be less valuable. Company A might earn the same as Company B next year. But there’s a good chance Company A enters bankruptcy after next year.
That’s why companies with too much debt naturally trades at low P/E. It doesn’t automatically mean Mr. Market has gone mad and now offers you a bargain!
And that’s why I hesitate when I hear pitches about how Charter Communications, Inc. (CHTR 0.00%↑ US) is such a bargain at 2x P/E.
It seems to have too much debt, especially with a shrinking broadband subscriber base.
2. P/E doesn’t account for poor quality earnings
Low P/E is meaningless if the earnings are poor quality.
We talked about how a Malaysian technology company was likely inflating its earnings by capitalising intangible assets aggressively.
At the start of the year, the shares were trading at 2x P/E. That isn’t cheap. That’s a warning.
So far, investors have lost -90%. But the drama doesn’t end here.
The government alleged the company owes them a lot of money, and is late in paying.
This wouldn’t come as a surprise to investors that paid attention to its aggressive capitalisation of intangibles.
Before you get excited over low P/E, ask yourself:
Why are other investors selling their shares at such a cheap price?
What are they overlooking?
What do I know that they don’t?
3. P/E doesn’t account for capital intensity
Charlie Munger quipped:1
“There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash.
It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business.”
Imagine two companies. Both will grow their earnings by $100 mn next year.
Company A must reinvest $50 mn into inventory, accounts receivable and PPE. Company B doesn’t need to reinvest its incremental earnings, leaving the full $100 mn for shareholders.
Which company’s earnings are more valuable?
Obviously, Company B.
B can distribute all its incremental $100 mn earnings to shareholders. Company A can only distribute $50 mn - what’s left after reinvesting in inventory, receivables and PPE.
In real life, B is like a software company. Before generative AI, software companies are generally better businesses because they are capital-light. They do not need to invest in inventories. Better still, customers even pay in advance, allowing their cash flow to exceed earnings.
Company A is like an equipment lessor. Very capital intensive. To grow, they need to reinvest a lot of earnings back into inventory, receivables and PPE. Customers can take a long time to pay them.
That’s why, all else equal, Company B deserves a higher P/E.
What determines capital intensity?
Return on incremental invested capital (ROIIC).
For the same amount of growth, if ROIIC is low, the reinvestment rate will be high. The opposite is also true.
That’s why a low ROIIC business trading at 10x P/E is not necessarily ‘cheaper’ than a high ROIIC one at 20x P/E.
Afterword
A better measure may be free cash flow yield (FCFF yield). That’s what I use mainly.
FCFF yield = sustainable free cash flow to firm / enterprise value.
Compare that to the risk-free rate, if the premium is big enough, then the shares may be attractive.
However, there are a lot of traps in estimating sustainable free cash flow.
The traditional formula ignores stock-based compensation, non-cash capex and capitalisation of intangibles, etc. These will inflate FCFF.
But that’s a story for another time.
Coming up next
Next week, I’ll be back with 2 to 3 more interesting ideas.
I’ll then analyse the most voted idea from my last post.
Right now, that’s Genting Singapore Limited (G13; GENS SP). ANTA Sports Products Limited (2020 HK) is the runner-up.
Haven’t voted yet? Check out my last post: 2 Attractive Ideas Again
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Disclaimer
This publication is for informational, educational, and entertainment purposes only and does not constitute financial, investment, legal, or tax advice. The content herein is a record of my personal research and investment process, and all analysis, forecasts, and opinions expressed are solely my own.
I make no representation or warranty, express or implied, as to the accuracy, completeness, or timeliness of the information provided. The stock market is highly volatile, and my forecasts, estimates, and assumptions may prove incorrect.
I am not acting as your financial advisor or fiduciary. You should not rely on any information in this publication to make investment decisions. Under no circumstances will I be held liable for any direct, indirect, or consequential losses or damages arising from your reliance on the content of this publication.
At the time of publication, I do not hold any positions in the companies mentioned in this article, either long or short. I may change my views, predictions, or personal portfolio positioning at any time without notice.
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