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P/E Is The Wrong Measure

September 30, 2011 Leave a comment Go to comments

Blogging buddy Andrew Hallam wrote a couple of months ago about how he was able to get Berkshire Hathaway shares for free. As he rightly illustrates, when the share prices approaches or falls below the book value of a business (what accountants say it’s worth) it can be a great opportunity. There’s still a possibility that management will waste that value and leave shareholders with nothing but I don’t see BH going that way.

That got me thinking… what Andrew is really saying is that you could buy the shares, receive assets of an equal value, and get the future earnings of the business for free. If you bought the whole company you could sell off the assets for the price you paid, ignoring the value of the future revenue.

Normally when we measure stock valuations we look at the P/E ratio which compares the total price of the shares (including asset values) to the earnings. What does this tell us? You could say that earnings have some relationship to assets which are needed to create them, but that’s likely to vary between different industries. If you buy shares in a $500m company that has $250m in assets and $50m in earnings, you’re really buying $250m in assets and paying another $250m just for the future earnings. But we overlook that with the P/E ratio and just say you’re buying $50m in earnings for $500m today.

On the other side, “value” indexes and strategies are often built on the price-to-book ratio which tells you how much you’re paying for the assets above their regular value. This tells us a bit more since it gets closer to the actual future value of the company, but if different companies need different levels of assets to produce the same earnings that will throw off the ratio. A P/B ratio of 3 in some industries might even be equivalent to 15 in others if they need much less assets!

It would be interesting to look at what you pay for a stock above the book value, and then compare that to the earnings. In other words Price – Book, divided by Earnings (call it ERV for Earnings Valuation). With the example above the company’s ERV ratio would be (500-250)/50 = 5x earnings, compared to a P/E ratio of 10x and P/B of 2x. This puts the assets to one side and measures what you’re really paying for the future income. However I’m not sure if this would be a useful measure at the market index level since there could be a lot of variation between companies and industries. And even though this sets aside the assets, we know that the company couldn’t earn the same revenue without those assets so they do have to be packaged in with the rest of the business.

It may be more useful as a way to see when a certain company is performing better than the rest of their industry by generating similar earnings with less assets. In a way this combines the P/E and P/B ratios into one number. Looking at Andrew’s example at $70/share, Berkshire Hathaway would have an ERV ratio of 1.2x earnings! This shows that 1.2 years after he bought the shares he will get an equal value back from the accumulated earnings and the assets (assuming no changes in asset values or earnings). If the price was twice the book value instead ($128.44), the ERV would be much higher at 13.3x.

If this is useful at all at the market level, it might be to signal when the market has more of a “value” orientation since it compares what shareholders pay above book value to get the earnings, instead of relating the price to the book value and ignoring the earnings.

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