Quality of Earnings & Flaws of the P/E Ratio

Often when analysts and market commentators talk about valuation of certain businesses, the method used is the price to earnings or P/E ratio. A price earnings ratio is calculated by dividing the current share price by the earnings per share (EPS), For example, a company trading at $1.00 per share with 10c of EPS is trading on a PE ratio of 10 times.

It is not uncommon for one to suggest that a company trading at a ratio 15 times is more expensive than a company trading on a ratio of 14 times, however that may not always be the case. The flaw with this method is that the ratio uses accounting earnings and not the cash the business receives. Due to the nature of accounting principles, companies have a degree of flexibility as to which items are included or omitted from accounting earnings.

The software company sector is one which could catch investors unaware. These companies will often spend a great deal of money on research and development (R&D) each year to improve their product. As a general rule, R&D costs should be put through the profit and loss account which would have an impact on accounting earnings by reducing the earnings per share and therefore increase the P/E ratio.

However, under certain circumstances, for example if the R&D is only for one clearly defined project, the company may choose to capitalise these costs bringing them on to the balance sheet. In this scenario, accounting earnings have been improved and therefore the P/E ratio is lower which makes the company look cheaper than its peers.

The key when looking at the earnings of a business is to work out how much the business requires in capitalised expenditure each year to maintain its competitive position. Buffett talked through this concept extensively in his 1986 letter to shareholders and coined the term “owner earnings.” He summarised the issue by stating “The accountants' job is to record, not to evaluate. The evaluation job falls to investors and managers.”

At NAOS Asset Management we view ourselves as ‘value managers’ but it is not always the stock on the lowest price to earnings ratio or the lowest price to book ratio that represents the greatest value. When we look at a business we place a far greater emphasis on coming up with a value for what we believe the recurring cash flows look like and how they may be allocated going forward.