Don't Be Misled By the P/E Ratio

By Nathan Slaughter
March 25, 2010

You might know the name Bill Miller. Aside from Warren Buffett, he could be the closest thing the investment world has to a rock star.

Every year, millions of investors set out with one goal in mind: to outperform the S&P 500. Miller's Legg Mason Value Trust did that for an impressive 15 years in a row.

That streak was finally broken in 2006, but his reputation was firmly cemented at that point. From his fund's inception in April 1982 until 2006, Miller steered his fund to annualized gains of 16%. That was good enough to turn a $10,000 investment into $395,000 -- about $156,000 more than a broad index fund would have returned.

After a long overdue slump, Miller's fund is back on top of the charts again. In fact, his fund's 47% gain during 2009 was 1,200 basis points ahead of the S&P 500.

Here's what you might not know. Miller achieved stardom and ran circles around other value fund managers by taking large stakes in companies like eBay (Nasdaq: EBAY), Google (Nasdaq: GOOG), and Amazon.com (Nasdaq: AMZN) -- highfliers that value purists wouldn't touch because of their high P/E ratios.

The message is clear: If P/E ratios are your only value barometer, then get ready to let some profits slip through your fingers. In fact, Investor's Business Daily has found that some of the market's biggest winners were trading at prices above 30 times earnings before they made their move.

All too often, novice investors buy into preconceived notions of what's cheap and what's expensive. A stock with a P/E below 10 may be a better deal than another trading at a P/E above 20. But then again it might not. These figures might get you in the ballpark -- but biting hook, line and sinker can cost you big.

Putting aside the fact that earnings can be inflated by asset sales, deflated by one-time charges, and distorted in other ways, let's remember that today is just a brief snapshot in time.

The point is, when you become a part owner in a company, you have a claim not just on today's earnings, but all future profits as well. The faster the company is growing, the more that future cash flow stream is worth to shareholders.

That's why Warren Buffett likes to say that "growth and value are joined at the hip."

You can't encapsulate the inherent value of a business in a P/E ratio. Take Amazon, for example, which has traded at 66 times earnings on average during the past five years. On occasion, the stock has garnered multiples above 80. Many looked at that figure and immediately dismissed the company as exorbitantly overpriced. And for most companies that would be true.

But as it turns out, the shares were actually cheap relative to what the e-commerce giant would soon become. In fact, the "expensive" $35 price tag from March 2005 is only about 12 times what the company earns per share now -- and guys like Bill Miller that spotted the firm's potential have since enjoyed 230% gains.

Digging into the annual report archives, I see where CEO Jeff Bezos applauded Amazon's sales of $148 million in 1997. Today, the firm rakes in that amount every 2.2 days. Clearly, that type of hyper-growth deserves a premium price.

And that's exactly why price-conscious value investors shouldn't automatically fear growth stocks -- growth is simply a component of value.

Let me show you an example. The table below depicts the impact of future cash flow growth assumptions on Company XYZ which trades today at $10. For the sake of consistency, we will keep all other variables constant.


 
If free cash flow climb at a modest 6% annual pace during the next five years, then your $10 investment in Company XYZ would be worth about $13.30 per share or a 33.0% return. If cash flow grows even faster, its projected value quickly ramps up to returns of 46.9%, 101.1% or even 148.8%.

We've been taught to believe there's an invisible velvet rope separating value stocks from growth stocks. But as you can see with Company XYZ, it's actually growth that determines value. So don't be blinded to the possibility that the market's most promising growth stocks can sometimes be the cheapest.

Many analysts choose to use the Price/Earnings to Growth (PEG) in addition to the P/E ratio. PEG is a simple calculation -- (P/E) / (Annual Earnings Growth Rate).

The PEG ratio is used to evaluate a stock's valuation while taking into account earnings growth. A rule of thumb is that a PEG of 1.0 indicates fair value, less than 1.0 indicates the stock is undervalued, and more than 1.0 indicates it's overvalued. Here's how it works:

If Stock ABC is trading with a P/E ratio of 25, a value investor might deem it "expensive." But if its earnings growth rate is projected to be 30%, its PEG ratio would be 25 / 30 PEG.83. The PEG ratio says that Stock ABC is undervalued relative to its growth potential.

It is important to realize that relying on one metric alone will almost never give you an accurate measure of value. Being able to use and interpret a number of measures will give you a better idea of the whole picture when evaluating a stock's performance and potential.