Value vs Valuation

People often refer to stocks as cheap or expensive. A common misconception is that this refers to a company's quoted price on the stock exchange. In fact share prices in a vacuum do not tell you very much about the value of a company or an ETF. What people tend to mean when they talk about the priciness of share prices is the ratio of the share price to the earnings per share (P/E ratio).

The higher that ratio, the more expensive the stock; the lower the ratio, the cheaper the stock. The reason share prices go up is because they should rise in line with earnings growth. If share prices go up much faster than earnings, the stock is deemed expensive and that is how bubbles can form (as was the case in the US market in 2000 and the Japanese market in 1989). The S&P 500's average P/E ratio has been around 16.24 (see below) over the last 26+ years, which suggests that that is about fair value for the average company in the S&P 500. Anything above that could mean stocks are overvalued (expensive), while anything below that value suggests that stocks could be undervalued (cheap). P/E ratios may therefore be a helpful way to determine the fair value of a company or an ETF. But, historically low interest rates and the rise of higher margin businesses through software adoption in recent years may in fact warrant the fair value P/E averages to increase in historical comparisons without necessarily being overvalued.

Warren Buffet usually looks to invest in companies that he believes are vastly undervalued, which is why he thrives during market crashes when the share prices are suppressed as people worry about business's earnings. This is when Buffet searches for bargains and then waits for earnings to recover after the recession is over and earning growth resumes. That might sound easier than it actually is as low P/E ratios can also signal that earnings may not return to growth, and may in fact decline. Low P/E ratios can therefore be a warning, while high P/E ratios may signal that earnings are expected to grow exponentially higher over the coming years, which is why people are willing to pay a higher share price now, expecting the company's share price to grow into its earnings. But those are not the sorts of gambles Buffet likes taking, risking instead to reach for "falling knives". As an example, when Buffet bought Kraft Heinz shares in 2013, a subtle trend was underway, not appreciated by fast-food loving Buffet, that had people increasingly snub Kraft Heinz's unhealthy snacks. And so after Buffet made a large investment into Kraft Heinz because the company looked incredibly cheap on a P/E ratio basis, earrings kept dropping year after year, culminating in a -60% drop in earnings at the end of 2018, and a share price drop of over 50% after Buffet's initial investment. Buffet simply did not anticipate demand for Kraft Heinz products to whittle away this fast as Kraft Heinz had been a staple in American household for decades. What we know now is that Kraft Heinz's low P/E ratio in 2013 was a warning sign rather than a buy signal.

What Buffet has instilled in the wider population is to buy companies with low P/E ratios. However, since Buffet started investing in 1950s, before the internet, the market has become a lot more efficient at pricing businesses. Hence, more often than not, low P/E ratio are waring signs and it has become a lot more profitable in recent years to invest in companies with high P/E ratios as this signals the enormous growth potential the market sees in these companies (Amazon, Netflix, etc.). As Buffet shuns these kind of companies for the most part, and undervalued companies have become a rarity, Buffet has had increasing difficulty investing his massive $128 billion pile of cash.

Companies with a high P/E ratio are usually referred to as growth companies. When valuing them on a P/E ratio basis they can look extremely expensive because the earnings part of the equation is often low, if there at all. In order to support growth, the gross income (earnings = net income) of these companies is often ploughed back into the business to feed further growth and establish a dominant position in what ever field they operate in. These might be companies fighting to replace Kraft Heinz on the supermarket shelves and are putting everything into the business to succeed. Some investors are therefore willing to accept low present earnings and prefer to bet on the future earnings potential of that company as long as that re-investment shows up in the gross income. Hence, growth companies perhaps rightly so, command premium share prices compared to their earnings, while value companies such as Kraft Heinz that are not re-investing as much of their gross income into R&D have higher net income and therefore lower P/E ratios. Yet, as history showed, that lack of re-investment can eventually lead to declining gross income.

As an example of a growth company with a high P/E ratio, take Netflix, for example with a P/E ratio north of 100. We said above that the S&P 500 had an average P/E ratio of 16.24 in an average year. Therefore Netflix appears extremely expensive and overvalued on that metric. Earnings are what is left after expenses are deducted from the gross income of a company. Netflix makes a lot of gross income but spends a lot of that to churn further subscriber and content growth, which in turn increases gross income, which in turn is re-invested again. As a result there isn't a lot of earnings left for shareholders. However, Netflix shareholders are willing to make that sacrifice as long as subscriber growth and thus gross income is actually increases as a result of this re-invested capital. The calculation is that if and when Netflix stops having to spend so much on subscribers and content, earnings will follow.

Hence, while a company is still growing, the P/E ratio isn't all that useful. It is only when a company stops having to spend so much money on growth (FUN FACT: Uber shareholders are actually subsidising 25% of every one of your Uber rides), and can instead focus on increasing product prices that a company has matured and earnings and therefore P/E ratios become more meaningful and useful to compare companies with one another.

Growth companies may be better valued on the basis of their gross income/sales ratio, especially when earnings are negative. On the P/E valuation growth companies appear incredibly "expensive" but should not necessarily be a reason to be put off the company as a viable investment. It could even be argued that the reason why the S&P 500's valuation has been increasing over the average 16.24 P/E ratio is because it is increasingly made up of these high P/E growth companies that are usually found in the tech sector as the world is increasingly digitising.