Every stock has a price, and while the market is open, we can track it by the second. At the same time, every stock has a value, which might be very different from its price, either higher or lower. The job of the financial analyst is to find those situations where price and value differ, and to buy and sell accordingly.

In financial analysis, there is no metric that is more universally used in stock valuation then the Price/Earnings ratio (P:E or P/E Ratio), which is the simply the current price of a stock divided by the reported or estimated earnings of the company, per share. The P:E ratio tells you how much you are paying per dollar of earnings, and obviously lower is better.

The P:E ratio was popularized by Benjamin Graham, widely recognized as the father of value investing and the mentor to Warren Buffet, in his book The Intelligent Investor, published in 1949.  In the subsequent 70 years, a large volume of academic work has shown that stocks with low P:Es have historically outperformed ones with high P:Es. The traditional explanation for the out-performance is mean reversion.  A high P:E indicates over optimism about a company’s future earnings, just as a low P:E ratio typically indicates strong pessimism over the prospects of the stock. Since the market can get overly pessimistic or optimistic about things in general, when things don’t turn out as well or as badly as expected, the share price will rise or fall accordingly.

We at Baskin Wealth Management obviously prefer paying cheaper prices for stocks, but there are a number of other very important things to consider when looking at the P:E of a stock:

  • Is the business structurally declining?

The assumption when buying a low P:E stock is that at some point in the future, the P:E will no longer be low because the price will rise relative to the earnings. For the multiple to expand however, earnings must remain stable. If earnings are falling, the P:E will rise without any increase in price. Stocks with low P:E ratios due to structural decline in the underlying business are generally described as “value traps”, as the unwary investor gets “trapped” by an illusion of value that is not really there.

  • Is this a cyclical business?

It is undeniable that certain industries are more sensitive to the business cycle than others. For example, home-building companies are cyclical because people tend to buy more houses and pay higher prices when the economy is good, and when mortgages are affordable. Paying an apparently low P:E ratio for a cyclical stock at or near the high point of the economic cycle can lead to very disappointing results if company earnings fall 50% when the economy goes into a decline or recession.

  • How much debt is in the capital structure?

A common reason why a stock has a low P:E ratio is because the company has a large debt burden on its balance sheet. In these cases, the low P:E is not a signal of cheapness but most likely reflects the higher level of risk in the capital structure since a heavily indebted company is much more vulnerable to unfavorable events and has less ability to re-invest in the business. Interest payments have the first claim on corporate revenue, and if all the earnings are going to pay interest, there is little left for shareholders.

  • How does the business reinvest in itself?

The above three reasons are fairly well understood by most investors when considering the P:E ratio of a stock, but the last reason is less often considered. A company’s earnings measure how much revenue is left in any period after all of the company’s expenses. Companies can often choose to increase spending on things like research and development on new products, and brand marketing, for the long-term health and growth of the business. These decrease the earnings of the business today, but are absolutely essential for future growth, and are what you want and expect the management of the company to do.

A good case study for all of the above is the Molson Coors Brewing Company. We formerly owned Molson Coors for many of our clients because of its dominant position in the North American beer market, but recently sold the stock. Molson Coors stock currently has a cheap P:E ratio of around 11x earnings vs around 20x for the S&P 500. The stock looks cheap on the surface. Looking past the P:E ratio however, there are a lot of risks in the business.

  • About 80% of Molson Coors’ sales are from mainstream beers such as Coors Light and Molson Canadian. Mainstream beer as a category is declining by around 1% to 2% per year in North America, as consumers are increasingly preferring more flavorful craft beers and other alcoholic drinks like spirits.
  • Molson Coors is also heavily indebted as a result of their acquisition of MillerCoors, which hampers the company’s ability to invest for future growth. If interest rates rise, debt will be a growing burden and will decrease earnings.
  • Most importantly, we grew concerned about management’s ability to execute in a declining industry. Profitability was maintained by cutting marketing expenses rather than through sales improvements and quarter after quarter, the management would tout new marketing campaigns that would turn the corner on volumes without showing much results.

After considering everything, 11x earnings suddenly does not seem so cheap after all.

By contrast, a stock we like and which we have started buying for clients is Activision Blizzard, which is one of the largest video game companies in the world. Activision Blizzard’s stock seems optically expensive at 23x estimated earnings. However, video games are an undeniably growing industry and Activision Blizzard has a good track record of building up and managing video game franchises while positioning its business to take full advantage of industry trends. A large, and unknown percentage of its spending on video game development is for new franchises that currently do not earn revenue but should generate significant benefit in the future when they are released. This hurts Activision Blizzard’s earnings today, but are important for the long-term growth of the business. Activision Blizzard also has a net cash position on its balance sheet, and has historically used this opportunistically whether for aggressive buybacks in the financial crisis, or for acquisitions. We think that the future is bright for Activision Blizzard, and do not at all mind paying an optically high P:E ratio for the stock today.

If stock analysis was easy, everyone would agree on the value of every stock. Daily price movements in the market reflect differing views as the day to day relationship between price and value. The P:E ratio is just one of the tools in our valuation tool box.