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PE is not a proxy for cheapness

December 15, 2012

 Every time you see the word EBITDA in a presentation, you should replace it with BULLSHIT EARNINGS, because that’s what they are!

Human understanding of complexity work on abstraction. He seeks examples, stories to comprehend reality better.But in this attempt a silent trade off is done.

When we try to parse data, comprehend ideas and make a decision we are called upon to deliberate on different perspectives and even weigh in the different facts to make a “well-informed decision”. However, human beings through millions of years of evolution have almost always learned to vote or veto. To make a clear distinction almost always bordering on the boolean system- true or false, yes or no etc, makes things simple and easy to decide. “He is good, he is bad. She is beautiful, she is ugly”. Boolean Information, boolean decision making.

But then, as man decided that he must settle down, he congregated together, invented religion and to propagate slightly more abstract ideas discovered the form of storytelling. The invention of stories was perhaps the turnpike of human civilization. Ideas could be propagated in an easier way, man learned to fine-tune his “weighing machine of facts and perspectives” and to make matters simpler philosophers started attaching morals to the stories to not only help man to understand reality but also make decisions for him. However storytellers soon realized that stories had to be simple. It can’t really talk about existential dilemmas because early human mind can’t handle dilemmas better. Dilemmas mean conflicting perspectives, hazy visualization and lack of plausible abstraction.

So in effect, stories by definition of being abstraction just reveal part of the reality to us. And in exchange of comprehension we choose to forego “fidelity”, complete insight and sometimes even make mistakes in understanding the problem at hand.

Price to Earnings ratio, just like others metrics and ratios tell a story. But like all stories its also guilty of abstraction. The reason for not  not using PE as a single point metric of the cheapness of a business stems from multiple ideas

  1. Turnaround/Cyclical: Cyclicity in business is one of the most often cited reason and doesn’t require more information. However turnaround because they are so rare in the world of business is a better candidate to be cited here. Many turnaround candidates quote low PE levels, reasons attributable sometimes to general market pessimism, pessimism towards the business or the sector or plain underestimation of the management or a combination of all three. However a low PE level and a possible turnaround in near future isnt the be-all and the end-all of investment in such cases. One in essence really needs to look into the interactions between the balance sheet and profit and loss statements. I.e in simpler words look at the real cash flow coming to the owners. PE deals with only one perspective, the GAAP bottomline. But it is not the true bottomline. The bottomline can be either more than this or less than this. A conservative investor needs to look into the free cash flow coming in because turnarounds can take a lot longer than anticipated and in such cases neither equity nor debt funding remains viable options. The only safety net on such occasions is the cash in the books and the cash from operations. Each reinforcing the other.Moral of the story: PE is not the true metric of cash flow here, and thus not the true proxy of valuation.
  2. Growth with a strong product pipeline:A high PE likewise is not a proxy for the dearness of the business. Nothing is more clearer in businesses than pharmaceuticals. Pharmaceuticals run on medicine launches, which are protected by patents from FDA often for a short duration of about 7 to 12 years. PE in those cases can drastically make a cheap company look costly. Of course, discounting properly the hype surrounding product launches.
  3. Ego vs Sanity: Often market in its wisdom falls in love with businesses which reek of ego and vanity. Airline business is one of them, Hotelling business is another-especially in the luxury segments. The high PEs awarded to those businesses during those periods are not a measure of their viability. And just on the other side, there are cash spewing extremely boring businesses. Lubrizol was one of them when Buffett scooped it up. FMCG companies do undergo such periods of pessimism.Sometimes morbid businesses like cemeteries etc traditionally reside in that blind spot of the market.Awarded a very low PE incommensurate with the fundamentals,the PE figure screams-“I am bankrupt, I am dead!” but then thats just a story.

I am sure there are many we can find ourselves if we wish to. Possible candidates are- business sales where PE can look ridiculously low because PAT is inflated by Exceptional Items, behaviour unbecoming of management and then an acquisition fuelled growth and the PE which can come from that.

PE is one of the most used and abused metric out there. EV/EBITDA is another. They all tell stories. Rationalizing them is a road to poorhouse. And even worse is believing the reasons given for its use without subjecting them to critical analysis. What can be the best practice for investors is to not look at them at the first glance, or even the second. Taking up the annual report is perhaps the best first course of action for us.

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