Talk of PE ratios is as popular as ever, even amongst investment professionals. At Blue Oceans Capital, we don't recognise them as valid. Let me explain.
The stock price (P) is just the market price of a share in a company at any given point in time - it's not a company valuation. The market moves every day due to factors that have nothing to do with individual companies. When the stock price does move due to factors actually relating to the company in question, it more often than not moves too far or too little in proportion to the new information. If the stock price matches a fair value it does so by chance, not design.
Earnings (E), comes from net income. Net income is an accounting calculation specifically for tax purposes. Net income is not actual cash flow from the business. It does not consider actual cash movements. For example, actual cost of asset replacement versus generic depreciation schedules, actual warranty expenses vs warranty reserves, amortisation of goodwill, capitalisation of intangibles, etc.
Implications
If you put P with E you don't have an answer, you don't have anything. To find value in stocks you will have to do three things. First, look at the business model and assess cash flow production and future prospects; second, value that company, discounting its future cash flows to today; and third, compare that valuation to the market price.
Assessing the business model
Is the business model sustainable, in that can it be sustained? By that I mean is this a business model that solves a problem in a manner that society approves of, and will likely require this need to be met, in this way, for a long time into the future? What are the drivers of price and volume? Can you understand them and do you know what influences them? To us this is the most important of the three parts of valuation. You can get your valuation wrong and still do well if you do this right.
Value the company using discount cash flows
We need to add up all the cash flows this company will produce into the future and discount them back to today's value. In doing that we need to make a few assumptions. How far into the future are we confident in making cash flow projections? What growth rate from today will we assign to future cash flows? What rate will we use in discounting those cash flows back to today? There are a few other parts to this to consider. At Blue Oceans Capital we think of valuations as buying the entire business today, collecting its cash flows over a period of time and then selling the whole business at some point in the future.
Compare that valuation to market price
The final step is to compare the valuation of a sound business model to the market price. Only at this point can we determine if the company represents value or not. If the stock price is high then the market has already valued in the company's future earnings in today's price. If your company has good fundamentals, then a fair or discounted price may represent a buying opportunity.
PE ratios are two erroneous metrics put together from which one can infer nothing. You cannot find value simply by looking down a list of PEs. At Blue Oceans Capital, we first scan for sound business models. This means manually looking over thousands of companies to understand their business models. Only after we have a small selection of companies that interest us do we then value them. Our final step is to compare that valuation to the current market price. If the price is too high we continue to watch the company’s developments and wait for a market pullback to take a position. In our opinion this is the only way to accurately find value investments.
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James Merabi
Discounted future cash flows IS the valuation of a company - both through the cash flow estimate and WACC/discount factor. So I agree that PE by itself is not useful but argue that it is an essential window into how dependent future cash flows are on growth and therefore how susceptible they are to disturbances. Future cash flows are ESTIMATES and if the more they rely on growth factors, the more susceptible they are to change with disturbances to the macro/micro environment. So the higher the PE, the greater probability that any macro/micro disturbance will have an impact on the value of the company - by changing those future cash flows. Totally agree that most who refer to PE as a deciding factor do so without understanding why.
Daniel Fu
Hi Will, You mentioned DCF is a key method to value a company. Tell me how a market can place a 'contemporary' market value of c$15.5bn on Afterpay - when APT has yet to post a single FCF in its history. In most sell-side reports i have witnessed, APT doesn't appear to be posting any FCF anytime soon (for the next 2-3 years at least) and APT's cash flow statement looks more like a typical bank type of cash flow statement. The difference is - unlike a bank, APT is unregulated, no requirement to provide capital reserve buffers and a glorified 60-day trade receivable companies. The reality for APT is unless it is proven otherwise this is a business currently entirely funded by debt availability and the occasional generosity of equity holders subscribing to additional shares into the market.
Will Simpson
@Daniel Fu. I agree Daniel. We were early investors in Afterpay but were forced to sell after waiting for years for cash flows from operations to eventuate. BNPL as a stand alone is inherently low margin. We have a different view on Zip and remain invested in that company.
Daniel Fu
Thanks for your comment Will. If i ascribe a 15% upside to APT's current market cap of $15.6bn (15% is the typical level a broker will use to justify a buy recommendation), it would equate to $17.9bn. Hence, i asked myself today - what would an APT free cash flow (FCF) profile need to look like in order to justify a $18bn market cap in today's value ? Using a 3.5% terminal growth rate, 9.0% discount rate and a hypothetical 5 year explicit free cash flow profile, i estimate APT would need to generate an accumulative free cash flow of at least $3.3bn over the next 5 years (FY21-FY25). That is a mother of all turnaround in cash flow generation fortune considering APT posted a FY19 FCF of -$173m and a few sell-side analysts forecasting -$500m FCF for FY20. To put the $3.3bn accumulative FCF over the next 5 years into context, it equates to c41% of CSL FCF generation prospects (as forecasted by some analysts) over the same period of time. If i further reverse engineer my DCF model with some generous assumptions on operational leverage and no change to the 4% fee it gets from retailers/merchants (a big IF considering the increasing competitive intensity racing into the BNPL segment), the implicit forecast for APT's transaction value is just mind-blowing. If this is not a bubble/hype/irrational optimism, i do not know what it is.