Using a stock’s price-to-earnings ratio can be a useful metric when the following four conditions exist: (1) interest rates remain in a narrow band; (2) the growth of the enterprise is consistent through the decades; (3) the quality of the balance sheet and general risk profile remain closely the same; and (4) the stock is non-cyclical. All of these character traits need to exist, otherwise the use of historical P/E ratios can be a red herring rather than a helpful investment aid.
Companies like AT&T or Realty Income deserve higher P/E ratios when interest rates are 2% compared to 8% as the purpose of the investment is usually a quasi-bond with a growth kick compared to something like Visa where the purpose is long-term future growth.
Also, the growth rate of the company needs to remain consistent, otherwise you will be using historical data that assumed different characteristics when making an investment decision. I argue that Nike is going through a golden age of growth right now as other nations clamor for its athleticwear and 12% earnings per share growth is trending towards 15% earnings growth, and this deservedly merits a higher P/E ratio. Other companies, like Campbell Soup, are having trouble experiencing growth (beyond the Pepperidge Farms division) and thus merit a lower P/E ratio to adjust for lower earnings per share growth expectations.
On the third element, changes in the balance sheet ought to change your perception of fair value for the stock. Right now, Johnson & Johnson is sitting on $32 billion in cash. That is an unusually high 11.3% of the overall market capitalization. If I were running a long-term account, I’d have no problem paying $102 for the stock right now. It’s not a bargain–but it’s a fair deal and the flexing of that cash muscle into acquisitions will eventually cause people to pine for the days when the stock could be bought for $102.
It’s this fourth element, however, that I want to talk about most–the inability to recognize that a great deal of companies are cyclical in nature, and this completely undermines the usefulness of the P/E ratio. In fact, it is often an opposite indicator–stocks appear cheapest precisely at the moment when they are the most expensive, and they appear the most expensive precisely when they are the cheapest.
To more fully explore the point, let’s consider something like BHP Billiton. In 1984, its earnings were strong at $6.15 per share. The stock traded at $58 per share. If you applied a P/E analysis to the company, the price might look reasonable. After all, the price was only 9.4x earnings. The error in this line of thinking is that it assumes earnings are going to continue to grow from that point; the reality was that the stock had just its cyclical high.
By 1986, when the economic slowdown in advanced commercial nations brought the price of oil down from $27 to $10, BHP Billiton saw its earnings collapse to $0.68. The price fell to $18 per share. The P/E ratio for the stock was 26. But it was irrelevant–the earnings were depressed, and were set to climb much higher over the long term. People who bought the stock in 1984 went on to compound at 8.5% through the present day, and people who bought the stock in 1986 went on to compound at 12.3% through the present day (the results were 11.5% annualized and 15.3% annualized through June 2014 before the recent downturn hit.)
This information should impart three lessons:
First, P/E ratios clearly are misleading with companies whose earnings fluctuate along with the economic cycle. Certain companies, like Deere, Aflac, and Conoco, will have stock price fluctuations that will take their long-term owners to hell and back. If you recognize this, and set aside cash to take advantage of the low point fluctuations, you can master the volatility instead of let it master you.
Secondly, the starting valuation matters a whole lot in determining your future returns. These two hypothetical scenarios with BHP Billiton involve someone owning the exact same oil fields, diamond mines, and metal processing facilities in 1987, 1988, 1989, 1990, 1991, 1992, 1993, 1994, 1995, 1996, 1997, 1998, 1999, 2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007, 2008, 2009, 2010, 2011, 2012, 2013, 2014, and 2015. These people owned the exact same asset during this time–half their investing life got spent owning the exact same thing, yet the person that got the 1986 valuation instead of the 1984 valuation earned an excess return of almost four points per year.
In conversation, it sounds about the same. What you really expect a meaningful difference between two cocktail partygoers, one of whom said “I’ve owned BHP Billiton for 29 years” and the other who said “I’ve owned BHP Billiton for 31 years.” No, it sounds exactly the same.
If anything, you’d intuitively expect the one who had been around for 31 years to have an excess 20% or so in total wealth from the stock. But the person who bought in 1984 established a base of 172 shares compounding assuming a $10,000 initial investment, and the 1986 investor got to spend a lifetime working from a base of 555 shares. There were dividend cuts and future fluctuations in the share price–heck, the latter event is happening right now and the former event may be happening soon–but the shareholders that gobbled up the cheap shares in 1986 are still doing quite well.
And thirdly, an attractive starting valuation can cause you to do well even when a lot of bad subsequent events happen. There is a reason why Benjamin Graham’s grave might as well be etched with the words “margin of safety.” It is a tremendous legacy to leave the civilization, and it provides great protections. BHP Billiton is down to $25 per share, and a 1986 investor still achieved over 12% returns from that time through the present day. If you lock in the stock while it is low, you will be positioned well during the inevitable moment decades later when the stock is again trading low.
BHP Billiton is down another 5% today, as analysts argue over whether the Brazilian spill was toxic and prominent investment banks question whether the $2.48 dividend can be maintained. This is causing many people to dump their BHP Billiton shares right before our very eyes.
I regard this move as a mistake. It is a common mistake, either driven by emotional or an incorrect reliance on the opposite condition of what textbook investment writers call “the peak earnings trap.”
Back in 2011, when earnings shot through the roof, BHP traded at $104 per share while earnings doubled to a high of $8.54. The P/E ratio of 12 seemed reasonable if you projected future growth perpetually outward. But that is not how cyclical stocks have ever worked, and now the earnings are down to $1.31. Even at this new low of $25 per share for the BBL shares, the P/E ratio is still 19. It doesn’t look a good deal, but it is enormously attractive–just as Benjamin Graham spoke of the ‘fat man’ test in conveying the notion that you don’t need to know a man’s exact weight to know whether he could use shedding a few pounds–you don’t need to know precisely the magnitude or the date of the energy recovery to figure out that BHP Billiton at $25 per share represents a tremendous deal for a stock that earns between $6 and $9 per share in profits during the good times.
Another piece of emotional baggage worth addressing is that there is a subset of investors out there that look stocks when they become cheap, but don’t like them when they become really cheap. During the financial crisis, American Express fell from $50 to $40. Many articles abounded touting its cheapness. Then, it fell to $30. Still, many comments discussing its cheapness. Then, American Express fell to $20. The previous people touting the low valuation got quiet. And by the time the stock hit $9, no one was telling you to buy it. True value investing involves escalating excitement about buying a company as its valuation becomes more depressed (absent an even greater true permanent earnings impairment.)
There are people out there that liked BHP Billiton when it fell to $40, but are backing off now that it is $25. I don’t find that behavior rational. Even at this low, BHP Billiton is still making $3.5 billion in net profit. If it cuts the dividend, there will be greater growth in the payout when prices recover (see General Electric and Wells Fargo post financial crisis for examples of this.) And if it maintains a high dividend payout, it will have hardly any dividend growth when oil recovers (see M&T Bank after the financial crisis for an example of this.)
The income will eventually come, the key is getting a good valuation. If you buy something absurdly low, you will eventually reap large capital gains and see a yield-on-cost that shoots through the roof. BHP Billiton is currently trading at an exceptional valuation, as it deals with industry and firm-specific headwinds. The key is to avoid making the intermediate investor mistake of running away precisely at the moment when the shares of cheapest because you are using inapplicable metrics for cyclical companies.