Speaker 1 (00:02):
Hello, and welcome to Actively Speaking. I'm your host, Steve Weiberg. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager.
Speaker 1 (00:16):
Hi, welcome to another episode of Actively Speaking. I'm, uh, Steve Weiberg, and my guest today is, is me. Uh, it's just gonna be me. Today, I'm going to talk about a white paper that I wrote last year, which is on a, on our website. Uh, of course our website is www.eipy.com. And, uh, the web, the, the white paper was called the PE ratio a users manual. Now, it may seem like, why do we need to talk about PE ratios? Everybody knows what they are, they're clearly, they're very straightforward. You know, what are, what are you talking about? A user's manual. I know how to use it. I would argue that the PE ratio is actually, well, it's, it's clearly one of the most widely used metric in investing, but I would argue that it is probably the most widely misused metric in investing. And so that's what I'm gonna talk about.
Speaker 1 (01:04):
And what do you really need to know to understand PE ratios better and use them sensibly? I think people recognize that if, if you really just take them at their simplest level and just say like, oh, well look, here's one stock that's trading at 20 times earnings, and there's one over there that's trading at 10 times earnings. Oh, clearly the one at 20 times earning is, is more expensive than the one that's trading at 10 times earnings. Well, you know, in a sense, it's, it's, uh, literally true. Uh, but literally, but in a meaningless way. In the same way that something that, you know, if you, you could go out and buy, um, you know, a piece of clothing that's, uh, $10 or another, that's $5. Does that mean the one that's $5 is cheaper? Well, it costs less money, but maybe that the $10 one is so much better made and so forth that it's, uh, it's more than worth the extra $5.
Speaker 1 (01:52):
So that issue comes up with PE ratios, uh, in the same way, something just because something is trading at a higher PE ratio, maybe there's something behind that. And the most obvious thing that people think of first when they think of, well, what, what would drive difference in PE ratios is growth. So, for example, what if the one that was trading at 20 times earnings, I suppose these two companies both have a dollar in earnings and one's trading at $20 and one's trading at $10, and that's why they have PEs of 20 and 10. Well, maybe the one that's trading at 20 times earnings. That dollar of earnings this year, most recent year, that's up from, you know, 80 cents the year before that, and 55 cents the year before that, and maybe only 20 cents the year before that. So this company's growing like gangbusters, and maybe the other one that's trading at 10 times earnings, maybe their dollar of earnings is actually maybe even down, maybe last year it was a dollar 10, and maybe two years ago it was a dollar 20.
Speaker 1 (02:49):
So in that case, the earnings are actually shrinking from year to year. Uh, people have a, a good and, and correct in intuition that, uh, that probably means that the, the first company should be trading at a higher multiple of today's earnings than, than the second if they're heading in such opposite directions. And so, uh, one of the metrics that people have used to try to correct for differences in growth is the so-called PEG ratio, which stands for a PE to growth. Uh, so suppose, uh, you had a company that had this, it was trading at 20 times earnings and had 10% growth. Well, the, the PE is 20, the growth is 10, so the PE to growth is two 20 over 10. And that would be using that metric, uh, equivalent to a company that's maybe the one that's trading at 10 times earnings.
Speaker 1 (03:36):
Maybe their growth is only 5%, you know, half as much as, uh, the one that's growing at 10. And so in that case, with a PE of 10 and a growth rate of five, it's the same peg ratio of two. So if you believe that PEG ratios correctly, um, adjust for growth, then two companies trading at the same PEG ratio are equivalently valued, uh, even if they have different growth rates. Well, is that true? And I'm gonna argue that it's not, uh, that it's really far from true to think about this. We need to understand what is, what is a PE ratio. Uh, you know, there's two things in it. There's a, in the numerator, we have a price, and then there's a denominator. We have the, you know, the current or the expected earnings. You can do it looking backward, most recent 12 months earnings or looking forward with the next 12 months earnings.
Speaker 1 (04:24):
But what, what is that? Uh, what does the price in the numerator tell us? You know, uh, economists are fond of saying that in any market system, prices contain information. Uh, if you see that the price of, uh, you know, bacon has gone up, you know, 50% in the last year, you might get a sense that, huh, something must have happened to the, the pork supply, the five pigs. Maybe there was some disease that killed awful large number of pigs. And so there's less of it around, there's less bacon around. And so the price has gone up. You know, that price, the movement and the price conveys information. You just need to know how to interpret the price and, and to understand what information is in that price. And with a commodity like bacon, it's pretty simple. It really has to do mostly with the supply and demand of the underlying commodity.
Speaker 1 (05:13):
But what about stocks? What, what is in the price of a stock, or what information can we glean from looking at a stock's price? Over the last a hundred years, there's been kind of a well-developed body of theory that's come along about what is reflected in stock prices. Uh, going back to, you know, John Burr Williams in the 1930s with the theory of investment value, uh, basically the line of thought that everybody has kind of, uh, congregated around is the idea that the price of a stock reflects three things. What are the, uh, what is the cash flow that you as an investor will receive from being an owner today or say this year? That's number one. So today's cash flow to me, the investor, number two, how is that gonna grow over time? Uh, it's not gonna grow at all then it's, it's more like a, a bond.
Speaker 1 (05:57):
It's just paying the same thing every year. It's like a perpetual bond. But if it's growing, that's, you know, that's better, presumably for the price of the stock if, if you're gonna get more cash going forward. So number two is what's the growth rate? And number three is we have to, uh, incorporate the concept of present value. Uh, if something is, if I'm gonna get a dollar a year from now, is that worth a dollar today? Well, one of the key concepts of finance is no, that's not the same, that there's this concept of the time value of money. Uh, because if I have a dollar today, I could, for example, with no risk invested in treasury bills and earn, you know, something like, uh, one and a half percent over the next year so that by a year from now I'd have $1 and one and a half cents.
Speaker 1 (06:38):
So if somebody says, I'll pay you a dollar a year from now, is that worth a dollar today? No, because the dollar today is actually worth more than a dollar and 1 cent a year from now. So you have to discount, uh, money in the future back by some discount rate. You have to, uh, you know, reduce its value to get its present value. And so the question is, what is that rate that you are gonna discount it by? So those are the three variables that really are in the information that's contained in the price of a stock is some expectations about, uh, what am I gonna get as an owner this year? How is that gonna grow? How's that cash flow to me gonna grow over time? And what's the right rate at which I should be discounting future cash flows into present value terms today?
Speaker 1 (07:22):
And that discount rate, lemme just spend a moment talking about that because we often talk about the role that interest rates play, for example, on PE ratios, and that when interest rates fall, it tends to push PE ratios up. And it's because of that discounting, uh, mechanism that when you use a a lower interest rate than, than money in the future is worth more than if you use a higher discount rate. But I, I do wanna stress the idea that when you're talking about stocks, interest rates have some impact on that discount rate, but it's, don't think of it as just an interest rate. It's, it's not that you would just, for example, use, you know, the 10 year treasury yield to discount stocks. That's, there was a so-called fed model that people talked about for years in which that was the way that worked.
Speaker 1 (08:04):
You just discounted future cash flows by the 10 year treasury yield, but really in, uh, what you should be discounting by is what is your opportunity cost If you're an equity investor and you're, you're offered the chance to buy into some company, and, uh, he said, well, what's my alternative? I could take that money and just buy a broad basket of stocks, in which case I would expect to earn something like the average return that the stock market generates over time. Let's just call that, you know, eight, nine, 10%, somewhere in that neighborhood. That's the historic numbers. So if I'm discounting cash flows that I'm gonna receive from a stock in the future, that's the, that's the rate I should be using is what's my expected return on equity investments, uh, in general. And, you know, maybe make some adjustment for the riskiness of a particular investment.
Speaker 1 (08:49):
If, if this is a very risky investment, I'd probably want to use a, a higher rate. If it's a, if it's a much safer equity investment, I might wanna use a lower rate, but it should be centered around that, that sort of expected return on equities over time. That's really what the, the return should be. So if you were gonna do this for a stock and say, okay, I'm gonna make my, uh, model of how this company's gonna behave over time, and I'm gonna try to estimate every year for the next 25 years, how much cash flow is gonna be, uh, left to, to me as the shareholder, first of all, that's probably a, a futile task because our ability to forecast, you know, 25 years into the future is, is zero. Uh, but suppose you did that. I mean, theoretically, the, the the right way to do this is to come up with some estimate of the cash flow every year.
Speaker 1 (09:33):
And, you know, maybe the growth is not gonna be the same from year to year. I mean, it rarely is. And so you have to come up in some estimate every year, what's the cash flow discount? Each year's cash flow back into present value terms by whatever the appropriate, uh, return is that you're using to discount it, and you add those all up. And that's what the value of the, the company would be. So it turns out that if you just make one simplifying assumption, uh, which is admittedly, you know, a little bit unrealistic, but it's not too unrealistic that it, uh, it's helpful to make it. Just to illustrate how this works, the one assumption you make is, let's just assume growth rate's gonna be constant over time. And if you do that, that whole endless string of, of terms in this calculation of, of each year's cash flow discounted, uh, at the appropriate rate over the appropriate number of years, it reduces to a single term, which just has in the numerator the cash flow you're gonna get the first year.
Speaker 1 (10:27):
And the denominator, it's just the, uh, that expected return that your, your required return as, as it's called, minus the growth rate, three terms. And it's those three things that that matter, which is, again, what are you gonna get? How's it gonna grow? How do you discount it? So just to give a quick numerical example to bring this to life, suppose there's a stock that this year is gonna pay me a dollar as the owner, I'm gonna get a dollar, uh, of cash flow from the company and I'm using a 10% required return as my discount rate. And the company's expected to grow over long term at 5%. So according to this model, which is, is referred to as the Gordon Growth Model, because there was a Canadian professor named Myron Gordon who wrote about this back in the 1950s. The numerator would just be that dollar that I'm gonna get, and the denominator would be 10% required return, minus 5% growth.
Speaker 1 (11:18):
That's a difference of 5%. So a dollar divided to by 0.05, that's $20. That stock is quote worth $20. That's what it should be trading at if it was gonna trade at fair value. So now it's, let's get back to our, our goal here, which is to figure out our PE and PEG ratio is meaningful in isolation. We don't know, well, what were the earnings that I said that I was gonna get a dollar in cash flow? Now, presumably there was more than a dollar in earnings, but I didn't specify what it was. Let's keep going and use some more examples to see why that if, if you do know what the earnings are, uh, it's not necessarily the case that peg, pe and PEG ratios tell you what you think they tell you. And to simplify this to make it clear, because we're, again, we're trying to figure out do, do peg ratios correct properly for growth?
Speaker 1 (12:04):
So to make it really simple, let's just take two companies and assume they have the same growth, right? Do And and suppose they also have the same earnings. They're, they're generating the same earnings and they're growing those earnings at the same rate. Well, does that mean that they're gonna generate the same cash flow to their investors necessarily? And the answer is no, it doesn't. Uh, because think about, uh, where does growth come from? How do companies grow? Well, generally growth requires that you invest some capital in the business doesn't just appear out of nowhere. And suppose these companies, uh, let's put some numbers on this. We've got company A and company B. They both got a dollar per share in earnings right now, and they're both growing at 5%. So that means they each need to generate another nickel in earnings next year. This year they earned a dollar, they're growing at 5%.
Speaker 1 (12:53):
What we mean by that is that next year earnings will be a dollar five. What is it gonna take to get there? And I say, well, they're gonna have to invest some capital. How much? Well, to answer that, you need to know what do they earn when they invest capital in their business. And that varies and can vary quite widely from one business to another. And the, the number that we're looking for here is what's called the return on invested capital. And what it means literally is if I invest another dollar into this business, what's my at the margin? How much more am I gonna get in profit from that investment? And if I invested dollar and it causes my earnings to grow by 20 cents, we'd say, well, that's a return on invested capital of 20% for each dollar you put in, you got an additional 20 cents out that year in profit.
Speaker 1 (13:40):
If I have an R O I C of only 10%, it means if I put in a dollar, I only get 10 cents back an additional profit. So we've got these two companies, A and B, they both have a dollar, they both want need to get to a dollar five next year to meet that 5% growth target. How much are they gonna need to invest to get there? It depends what their R O I C is. Let's keep going and suppose that A does earn the 20% R O I C that I started with. So to get another 5 cents in, in profit per share with a 20% R O I C, well that means they need to invest 25 cents, uh, of their dollar in profit because 20% of 25 cents is 5 cents. So that will grow their profits by 5 cents. Well, if they're reinvesting 25 cents of their dollar in profit, that means they still have 75 cents left that they can pay out to me, the owner of the business.
Speaker 1 (14:32):
And if we plug that into our Gordon Growth Model formula, well now our numerator is 75 cents and our denominator is still that 10% minus 5% the, the required return minus the growth rate. So that's 75 cents divided by 0.05. That equals $15 a share. Uh, remember they have $1 in earnings and they're growing at 5%. So with a price of 15, that gives you a PE of 15 since the new denominator is won and the PEG ratio is three, uh, a PE of 15 on a growth rate of of five, that's a PE to growth ratio of three. Now let's go back to company B. They're the ones that have only a 10% return on invested capital. Well, if they want to get 5 cents more in additional profit, they've gotta invest 50 cents of their dollar in profit because 10% of 50 cents is 5 cents. But if they invest, if they reinvest 50 cents of their dollar in profit, they only have 50 cents left of that to actually pay out to the owner of the business.
Speaker 1 (15:31):
And when you plug that into the formula, it turns out that stock should trade at $10 a share. Uh, cuz it's 50 cents divided by 0.05, which means their PE is 10 and their pay ratio is two cuz it's a PE of 10 and a growth rate to five. Okay? So is is one of those companies cheaper than the other? Well, B has a PE of 10 and a PEG ratio of two A has a PE of 15 and a PEG ratio of three. A believer, somebody who believes that PEG ratios correctly adjust for growth would say, ah, well A is more expensive than B. Uh, you know, not only is the PE higher, but even when we adjust for growth, and of course we consciously said growth the same for both companies here, it has a higher peg ratio, but we, you know, the whole point of this example is that we calculated the fair price for both companies.
Speaker 1 (16:22):
This is what they are intrinsically worth according to the Gordon growth model formula. And so it's quite clear that, uh, if you rely on the PE and PEG ratio alone, without digging into the details, uh, of what's driving, uh, the, you know, the reinvestment rate for each company, how much do they need to reinvest? Where does that cash flow in the numerator come from? Uh, you can come to very erroneous conclusions. I mean, suppose for example, uh, company A was not trading at $15 a share. What if it was trading at $14 a share? Uh, well that would mean its PE was 14 and its peg ratio would be 2.8. Uh, and what if B was not trading at $10 a share, but at $11 a share? So its PE would now be up to 11 and its peg ratio would be up to 2.2.
Speaker 1 (17:07):
Well, again, if you just took the numbers, uh, on face value and compared them, you'd say, oh B is cheaper. It's got a lower PE ratio and a lower PEG ratio. But based on the analysis we just did of what their fair values are, A is actually undervalued and b is overvalued even with its lower PE and its lower PEG ratio. So that's kind of a key conclusion that you cannot use PE and PEG ratios in isolation. Um, that if you don't understand what's driving the numbers, uh, behind the scenes, what information is actually communicated by that price. Uh, you can come to very wrong conclusions about what looks cheap and what looks expensive. So how can you apply this in the real world? Uh, well I would, I would say that, um, what you need to do is you need to always remember, as I've said, the PE ratio contains information about what the market believes about.
Speaker 1 (18:00):
Three things about what's the cash flow gonna be this year from a company? What's the required return that you should be using to discount future cash flows and what's the growth rate of those future cash flows? That's what's in the price. So when you look at the price and, and then therefore the PE ratio, cuz that's the, you know, the PE is in the PE ratio, the price is in the PE ratio. You are looking at information about cash flow today, future growth of cash flow and the appropriate discount rate. That's what the price is telling you. And so you, you need to be aware of that. So what I would say is, uh, in understanding how to use PE and pig ratios, it's more, perhaps maybe the way to phrase it is how not to use them. So for example, when you're comparing two stocks, as we saw before with when we were looking at our example of A and B, if you just use 'em on a standalone basis, they can, they can lead you to completely the wrong conclusion.
Speaker 1 (18:51):
If you're looking at two companies and comparing them with those metrics, you need to know more than just those metrics. You need to know what each company's return on invested capital is because the return on invested capital determines what the reinvestment rate is that's needed to generate the growth that they're experiencing. And that in turn determines how much is left to pay out to the owners of the business. This might be a good point to just mention that there, you know, there's a trade off between the those variables, those three variables between two of them anyway. Uh, today's cashflow and future growth, they're not independent of each other. It's just worth dwelling on that for a minute. If, if you're the management of a company, the company has generated, you know, this, this profit you are faced with, what do we do with it? We're always talking about this at Epic, about the uses of, of cash flow and, and how management allocates amongst the various uses of cash flow.
Speaker 1 (19:37):
Because broadly speaking, there's two things you can do with it. You can reinvest it in the business or you can give it to the own, to the shareholders, the owners of the business. And there's different ways to do each of those two things, but those are the two broad buckets. And, uh, you're always faced with this question of, well, you know, how much should we reinvest in? How much should we give back to the shareholders? Because the more you, obviously, if you think about that Gordon growth model formula where the, the numerator is cash flow you're gonna pay out today. So obviously if you can raise that number that that would push the price higher, but so you might say, oh, just pay out all the cash flow, it will get a higher price. Yeah, but if you do that, you're kind of starving the company of future growth in and if you reduce the growth rate in the denominator, you reduce the price of the stock.
Speaker 1 (20:21):
So there's this tension between the those two, like, how much do I pay out? How much do I reinvest? Because they pull in opposite directions in terms of price and what mediates that, uh, or sort of triangulates that trade off is return on invested capital. That's the point we like to make, is that if by reinvesting in the business you are going to generate a return on that invested capital that's greater than that cost of capital or that required return that investors are demanding, then the higher growth rate in the denominator will win out over the lower cash flow upfront in the numerator and, and the growth will make sense. But if reinvesting in the business is gonna earn a lower return on invested capital, then the required return that investors' demand, then the, uh, reduced cash flow in the numerator will more than offset the, the growth in the denominator, the higher growth in the denominator, and you'll be reducing, uh, the value of the business.
Speaker 1 (21:13):
You know, that's really a key concept as well is that there's, there's an inherent trade off between cash flow today versus growth in the future. And that the, the way you figure out which is the right thing to do is by looking at return on invested capital versus cost of capital. Coming back to our discussion of how do you use this insight about PE and Pega issues in the real world. Again, the first one was, when you compare two stocks, you need to understand the ROI c dynamics between the two stocks. Secondly, I would say if you're looking at a stock just in isolation, people will often, uh, use a line of argument like, well, you know, this, this company has traditionally or historically anyway traded between, you know, say 16 and 19 times earnings, and today it's trading at 14 times earnings. And so therefore it is cheap because, you know, there's an implicit assumption there that nothing has actually changed that should make the company trade at a lower multiple and it will therefore revert to that range of 16 to 19 and therefore buying it at 14 is a good investment.
Speaker 1 (22:12):
Well, again, you know, everything we've been saying here is the price contains information and the market is telling you something. If the stocks now trading at 14 times earnings, ask yourself, what is the market trying to tell me? Now the market could be wrong, but the market has a belief embedded in that price that either the r YC is deteriorating or the growth rate is deteriorating something the market believes something is different today, uh, about that company than was the case when it was trading between 16 and 19 times earnings. And you need to ask yourself, is the market right or wrong about that? What does it think has changed? Because you can, you can kind of back out, you know, you can look at a, at a price and using that Gordon growth model for you can back out various combinations of these three variables, you know, cashflow today, proper discount rate or expect or required return and growth rate.
Speaker 1 (23:01):
You can come up with different combinations that will lead to this, to this price being correct. And you can ask yourself, do any of those scenarios make sense? Or if you think none of them make sense, well then maybe the price really is, you know, quote wrong and there's a, a profitable opportunity there. But that's the way you have to think about it. Not just don't treat the PE ratio as if it's a fundamental characteristic in its own right, which, which follows its own laws. You know, like a well it has to revert to its mean value of the last 10 years. That's, that's not true. The PE is not a fundamental characteristic, it's just a residual or sort of a derivative of the three fundamental characteristics that we're talking about, which are the, the required return, the growth rate, the cash flow today. Those are the fundamental characteristics you need to focus on.
Speaker 1 (23:42):
Don't focus on the PE or the Pega issue in isolation. I I would summarize this whole thing. There's a couple of statements, uh, we make in the white paper that I think summarize this well. Number one, so the current free cash flow of a business and the future growth of that cash flow, they both drive the value of a business, but there's an inherent trade off between the two. And the variable that ultimately determines the outcome of that trade off is return on invested capital. And number two, uh, without an analysis that incorporates return on invested capital, PE and PEG ratios are totally inadequate and potentially very misleading metrics. There's no absolute standard for saying that any particular PE ratio or peg ratio is, is cheap or expensive and even on a relative basis, a company with a lower PE or PEG ratio is not necessarily cheaper than a company with higher ratios. So those, those are I think, the key takeaways from the paper and hopefully, uh, I've given you some insight to help understand why we believe those statements today. If you want to, uh, learn more, you can go to our website and you can find the white paper there. Thanks for listening and we'll be back to talk to you again soon. Remember to subscribe to actively speaking on Apple Podcast, Spotify or Google Play. You can find all of our previous episodes and additional content on our website, www.eipny.com.
Speaker 2 (25:04):
The information contained in this podcast is distributed for informational purposes only and should not be considered investment advice or recommendation of any particular security strategy or investment. Product. Information contained herein has been obtained from sources believed to be reliable but not guaranteed. The information contained in this podcast is accurate as of the date submitted, but is subject to change any performance information. Reference in this podcast represents past performance and is not indicative of future returns. Any projections, targets, or estimates in this podcast are forward-looking statements and are based on epic's research, analysis and assumptions made by Epic. There can be no assurances that such projections, targets or estimates will occur and the actual results may materially be different. Other events which were not taken into account in formulating such projections, targets or estimates may occur and may significantly affect the returned or performance of any accounts and or funds managed by Epic. To the extent this podcast contains information about specific companies or securities, including whether they are profitable or not, they are being provided as a means of illustrating our investment thesis. Past references to specific companies or securities are not a complete list of securities selected for clients and not all securities selected for clients in the past year were profitable.
Speaker 3 (26:32):
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