The P/E Ratio Is the King of Valuation Metrics

In the year 2000, Enron had a P/E ratio of around 60. Wall Street ana­lysts were trip­ping over each oth­er to slap “Strong Buy” rat­ings on it. For­tune mag­a­zine named it “Amer­i­ca’s Most Inno­v­a­tive Com­pa­ny” for six con­sec­u­tive years. The P/E ratio said it was expen­sive but wor­thy of the pre­mi­um. The busi­ness, it turned out, was a spec­tac­u­lar fraud. With­in eigh­teen months, it was rub­ble.

The P/E ratio did not see it com­ing. It nev­er does.

The First Metric You Learn Is the Least Reliable One

One of the first met­rics you’ll encounter when you start your invest­ing jour­ney is the P/E Ratio — the price-to-earn­ings ratio. It’s cal­cu­lat­ed by divid­ing the cur­rent share price by earn­ings per share (EPS), and it’s every­where. Ana­lysts cite it, finan­cial jour­nal­ists lean on it, and it’s the first num­ber that comes up when­ev­er some­one asks whether a stock looks “cheap” or “expen­sive.”

Which makes it a prob­lem. Because it’s also one of the eas­i­est num­bers to manip­u­late.

Why People Believe It

The appeal is obvi­ous. The P/E ratio is sim­ple. You can look it up in three sec­onds. It gives you a num­ber, and num­bers feel objec­tive. A P/E of 10 feels like a bar­gain. A P/E of 50 feels alarm­ing. This appar­ent clar­i­ty is enor­mous­ly com­fort­ing in a world that’s oth­er­wise messy and unpre­dictable.

There’s also the his­tor­i­cal pedi­gree. Ben­jamin Gra­ham, the god­fa­ther of val­ue invest­ing, used earn­ings as a core part of his val­u­a­tion frame­work. And when Gra­ham is your intel­lec­tu­al ances­tor, the idea car­ries real weight.

But here’s the thing about earn­ings: they’re a man­age­ment deci­sion.

The Levers Behind the Number

Let me put it this way. If you offered me a 50% share of your cof­fee shop for $100,000, the first ques­tion I’d ask is: how much cash is the busi­ness actu­al­ly gen­er­at­ing?

If you told me $200,000 a year in cash flow, I know I’d get my mon­ey back quick­ly — in rough terms, about a year, with zero over­heads fac­tored in. That’s a con­ver­sa­tion worth hav­ing. If you told me the busi­ness was gen­er­at­ing $10,000 a year, I know it’s going to take twen­ty years to get my mon­ey back. And twen­ty years is a long time. Think about what the world looked like twen­ty years ago. We were car­ry­ing Nokia 3310s and think­ing Nap­ster was a per­ma­nent lifestyle. A lot can change.

Cash flow tells me some­thing real. Earn­ings tell me some­thing that was con­struct­ed.

When we start­ed doing the pod­cast, Tony explained the prob­lem with earn­ings this way:

“What I’ve found over the years is that the fur­ther you go down a com­pa­ny’s finan­cial reports, the more it becomes a man­age­ment deci­sion as to what fig­ures get put in there. Oper­at­ing cash flow, at the top of the state­ments, is the hard­est thing to manip­u­late. Earn­ings are not. A man­ag­er can pull lots of levers across the three account­ing state­ments — pro­vi­sions on the bal­ance sheet, adjust­ments to depre­ci­a­tion, deci­sions about good­will amor­ti­sa­tion — to make their num­bers look how­ev­er they want them to look. Some­times they do it to hit a bonus tar­get. Some­times they do it to make next year’s com­par­isons eas­i­er. I’m not say­ing all man­agers are crooked. But it’s human nature to present your­self in the best pos­si­ble light.”

This is why the big scan­dals — Enron, World­Com, HIH in Aus­tralia — are always earn­ings scan­dals. Nobody fakes the cash com­ing through the front door. That’s much hard­er to hide.

What We Use Instead

When you start using QAV, you’ll see we focus on a met­ric called Price-to-Oper­at­ing Cash Flow — which we call PROPCAF.

Unlike earn­ings, oper­at­ing cash flow is the real mon­ey a busi­ness is gen­er­at­ing from its actu­al oper­a­tions, before the accoun­tants have had a chance to finesse it. It sits at the top of the cash flow state­ment, and com­pa­nies are legal­ly required to report it. The fur­ther down the finan­cial state­ments you go, the more room there is for inter­pre­ta­tion. Oper­at­ing cash flow sits right up there at the top, in the clear­est pos­si­ble air.

Over years of regres­sion test­ing our check­list, we’ve found that PROPCAF is one of the sin­gle most pow­er­ful met­rics we have. When we strip every­thing else out and test our met­rics indi­vid­u­al­ly, PROPCAF by itself deliv­ers the most out­per­for­mance of any sin­gle vari­able. Every­thing else we check — man­age­ment own­er­ship, finan­cial health scores, rev­enue trends — adds to the result, but PROPCAF does the lion’s share of the work.

We Don’t Completely Ignore P/E

To be clear, we haven’t thrown P/E in the bin entire­ly. One of our check­list items looks at whether the cur­rent P/E is the low­est it’s been over the last three years — which is a use­ful sig­nal that a stock is cheap rel­a­tive to its own his­to­ry.

But we’re not using P/E as a north star. We’re using it as a sin­gle data point in a much more rig­or­ous frame­work. One instru­ment on a large dash­board, not the whole instru­ment pan­el.

The Question to Ask

So the next time some­one tells you a stock looks cheap because the P/E is low, ask them one ques­tion: What’s the oper­at­ing cash flow look like?

Because earn­ings are what man­age­ment wants you to see. Cash flow is what’s actu­al­ly hap­pen­ing.

At QAV, we’ll always take the real thing.

---

---

QAV Myth Killers is a week­ly col­umn in the QAV newslet­ter, tak­ing apart a piece of
invest­ing con­ven­tion­al wis­dom. Read the series, or
get it by email every Fri­day.

Gen­er­al advice only. Space­craft Pub­lish­ing Pty Ltd
trad­ing as QAV is a Cor­po­rate Autho­rised Rep­re­sen­ta­tive (CAR 001292718) of MF & Co.
Asset Man­age­ment Pty Ltd (AFSL 520442). This is gen­er­al infor­ma­tion and does not take your
per­son­al cir­cum­stances into account. See our
dis­clo­sure.