Why The P/E And P/B Ratios Are Not The Holy Grail Of Valuations

To measure whether a stock/mutual fund/ETF is cheap or dear, we need to employ the help of stock valuations. There are various stock valuation ratios, the most popular ones are price/earnings, price/book, price/sale, price/cash flow and dividend yield. Out of the five, the most commonly used ones are perhaps the P/E and P/B ratios. The 2 ratios are relatively easy to visualize and stock analysts and the press like to quote them on a regular basis. In particular, the P/E ratio is frequently compared to its historical average of 15 to justify whether to buy, sell or hold. While the values are great tools of the trade, the valuations need to be taken with a pinch of salt. You’ve to understand the nuances involved to make use of them.

First the P/E, the reverse of P/E is the E/P. This is commonly known as the earning yield. Some people argued that the long term real rate of return of a stock can be estimated using the earning yield. Sooner or later, they reasoned, the earning yields will be distributed to the shareholders via dividends or a liquidation of the business. Why it is a real return is because the underlying company holds onto productive real assets that can go up in prices in time with the inflation rates. However, this fallacy about using the P/E ratio as a return measure is unjustified as we shall see in a short while.

I do a little bit of spreadsheet from the excellent website http://www.multpl.com/. The historical S&P prices are from 1881 till 2012 so the range is of the longest possible term. Annualized earning yield (E/P) from the range of data is 7.03%. Dividend yield is 4.28% and annualized real price increase is 1.67%. As you can see, the total return from S&P500 is 5.95% which is 1.08% lower than the earning yield. While 1.08% might seem like a small amount over a single year, it can compound to a princely sum over 13 decades. In fact, if you invest in index funds/ETFs, the amount can pay for the expense ratio several times over!

Why it is the case where there is a difference is indeed puzzling; we can only speculate about the reasons. One reason could possibly be because of stock options. Over most of the history, stock options are granted as is without a need for the corporate to expense it. Thus, the earnings of the S&P500 companies are overvalued by the amount of the stock options granted. Luckily for us investors, stock exchanges worldwide are moving towards a regime where stock options now have to be expensed by regulation. This is good news as earnings are now more accurately recorded and corporations will not grant stock options haphazardly as it now impacts its bottom line. However, the issue is not fully resolved yet as companies still can play around with the valuations of the stock options. Since stock options are converted into actual stocks in the future, we do not know the actual value of the stock options granted when it’s issued. The most common way out is to estimate the value of the stock options via Black-Scholes option pricing model. As the calculation requires the input of the volatility of the underlying stocks, companies have the leg room to wriggle with the pricing by choosing a volatility that suits them.

Besides stock options, another reason might be the accounting methodology used. While we have been using the GAAP standard for many years, the standard still leaves some room for corporate shenanigan. However, it’s nevertheless the gold standard and will serve us well for many more years to come.

The third reason could be because of downright corporate thievery. While the corporate structure might be strict, real assets could however be moved out or stolen from the company without the management knowing about it.

Besides the differences between earning yields and actual returns, P/E also suffers from the problem of having different methodologies of calculating it.  In general, there’re 2 ways to calculate P/E – the trailing P/E and the projected P/E.  Both have their merits and downsides, trailing P/E shines as it’s the actual P/E recorded by the accounting data but it lacks recentness.  Projected P/E is great as it’s forward-looking but its downside is that it’s projected information, which isn’t accurate.  Besides, projected P/E has the problem of being too optimistic on the earnings as the analysts who do the projections on the stocks have their hands in the investment banking business.  There is thus a conflict of interest involved.

So much so about the P/E ratio, we next talk about the P/B ratio. While P/B is an important ratio, however, it has its flaws. Book value measures only the value at which the assets are carried on the balance sheets. It does not calculate or attempt to calculate the “software” part of the company. This issue is particularly important since we are moving from a manufacturing economy to a service/information era. The technical knowhow and finesse of employees and management are not valued. Brands are not valued. Computer system crafted by skill programmers are also expensed and not valued.

If you think that P/B ratios have been rising over the years as we moved towards an informational era, you’re right! Large-blend stocks B/P (the inverse of P/B) has reduced from 1.01 in 1926 to 0.57 in 2011. Large-growth stocks B/P has reduced from 0.46 to 0.24. The reduction in book value is tremendous, so much so that historical comparison is no longer valid. This is very much unlike the P/E ratio whose values are historically relevant.

Some value investors, such as Benjamin Graham, exclude intangible assets and good will from the P/B calculation.  This form of book value is commonly known as net tangible assets.  Although intangible assets and good will are there in the financial statements for a reason, net tangible assets calculation does have a point in the evaluation of a company’s financial statement.  It is best for the cautious investor to take heel of both figures in his judgement call.

As you can see, P/E and P/B ratios are not the holy grail of valuations. However, P/E and P/B are still important considerations given the caveats that we have seen.

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