P/E ratios misleading investors

P/E takes the P/E, as one of my colleagues highlighted yesterday with some aplomb. I’m not sure I would have put it so eloquently myself, but I understand the spirit in which it is intended.

The value of the price/earnings ratio as a true reflection of a company’s value has been up for contention for many years. Just to recap, it’s the ratio of a company's current share price over its earnings per share. The higher the P/E (or multiple), the harder and faster a company is expected to grow, and vice versa.

The investment world has always known that P/Es cannot predict the whole story, but this didn’t stop us all from ploughing into tech stocks at the turn of the century, when ridiculous double-digit (if not higher) multiples were normalised in the popular mind.

It helped (and rightly so) to discredit the overwhelming emphasis placed on the ratio, and now it’s come under scrutiny again owing to an insightful piece of research from Deutsche Bank.

The basic premise of our argument is that P/E is only as good as the forecast of the ‘E’. If the ‘E’ is no good, then how can it possibly be a fair measure of a company’s value? We all know that ‘E’ can be smoothed over with a bit of accounting magic.

Deutsche extrapolates this final point very well, revealing that the effects of inflation are rarely accounted for. We have all assumed at some point that equities provide a hedge against inflation, because nominal earnings and dividends rise faster in an inflationary environment.

However, beneath the surface, the value of free cash-flow – the lifeblood of any business – is eroded. Investors have clocked on to this dis-join, and P/Es have been hammered accordingly. The extent of erosion is not always reflected in reported earnings, even though it appears to have a much greater impact than debt on capital-intensive businesses.

The bottom line is yes, equities can offer a hedge against inflation, but careful selection, based on fundamental analysis, is crucial. In light of this and similar research, we need to be clear about how we define pricing power.

Julian Chillingworth is chief investment officer for Rathbone Unit Trust Management. The views expressed here are his own.