The two lethal flaws in your favourite investment tool

The price to earnings (P/E) ratio is one of the most widely used investment tools, which allows investors to gauge the value of a company's shares. But the popular ratio has two fatal flaws, writes Bengt Saelensminde.

There are two very important things you need to know as an investor. And both are captured beautifully by one thing - the Price Earnings (P/E) ratio.

It's the simplicity of comparing price to earnings that makes this ratio so powerful. We understand what the ratio represents on a gut level.

In fact we make this calculation ourselves on a daily basis. It doesn't matter if you are a builder, a housewife or a country doctor, it's the same story: whenever you buy something, you begin weighing up the benefits against the price you have to pay.

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Is the extra benefit of the diesel model of that car worth paying an extra grand? Are the Heinz beans worth the extra 20p? It all boils down to our golden ratio - benefit to price. That's why the PE ratio has become the most popular investment tool around.

But this elegant simplicity masks some problems.

Today I want to deal with two potentially fatal flaws with the PE ratio. And then I'll show you how you can tweak the PE ratio to overcome these flaws - and maybe get a leg up on the majority of investors.

The first pitfall with the golden ratio

I've just downloaded theFTSE all share index of stocks and ordered them by PE ratio. And boy did that throw up some interesting valuations...

There are loads of stocks trading at under one times earnings. How can that be? I mean, that means these companies are worth less than the profit they make in a single year! Sounds a little weird doesn't it... you shouldn't be able to buy a stock for a quid that's going to earn you back a quid within one year would you? That would be a 100% return each and every year.

Something's clearly not right. And that something is old earnings data. Most of the PE ratios you'll see are what we call historic PE. It uses the earnings figure from last year.

Take HMV - they're currently trading at 25p (that's P), and last year they made earnings (E) of 12.5p per share. So, that puts them on a PE of only 2 times (2512.5 = 2). But remember, that's last year's earnings.

Next year earnings may be very different. We've discussed the disease infecting this patient in previous issues - the move towards music downloads, online sales and to top it off, supermarket encroachment into non-food' retailing.

And that's why a better figure to use is what's known as prospective earnings. That means the earnings HMV is likely to make next year. Of course nobody knows for sure, but that doesn't stop the analysts from having a go at guessing...

Analysts predict that profits will fall from 12.7p in 2010, to just under 8p per share in 2011 - putting the shares on a prospective PE of 3 times.

But hang on, I hear you say. That's still cheap... and you're right, it is. And this brings us on to the second pitfall awaiting unwary investors...

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Are you ever going to receive your benefits?

Now, maybe HMV will earn 8p per share next year. But, and this is a massive BUT: what's the point in earning 8p a share, if shareholders won't get to see any of it? Where is your benefit?

In HMV's latest trading statement, they said, "compliance with the April covenant test under the Group's bank facility will be tight..."

This is the last thing a shareholder wants to hear. The first duty of the business is to ensure the bank's terms are met... if they don't, they could go bust! And paying off the banker will probably mean less money for shareholders.

Analysts reckon the dividend will be slashed from 7.4p to around 2p this year. And who knows where it'll be the year after that? After all, this looks like a company in structural decline' - bit by bit, it's disappearing. And as earnings get swallowed up in repaying debt and exceptional costs' like closing down stores, you may never get to see any of these so-called profits.

When a stock is in transition, like HMV is ... and it has to pay out on exceptional' items and retiring debt, we need to be a little bit more flexible with the P/E ratio.

Specifically, we need to adjust the earnings side of the ratio. Rather than use earnings, it's probably better to use free cash flow.' This is the money that's left after paying out all the other expenses keeping shareholders from their dividend...

Make up your own ratio

Stock market prizes rarely go to the lazy. Anybody can simply gamble on the stocks with the lowest PE ratios. We need to be a bit smarter than that.

Look back at old company reports and get a handle on exceptional costs' - I mean, if they go on year-in-year-out, they're hardly exceptional are they? In HMV's case, see what it costs to shut down a store. After all, they're planning on closing 60 of them this year!

Take a look at the company debt and any covenants (promises made to lenders) - try to work out how much cash may be earmarked for repaying debt.

After you've made your adjustments, you'll have a much better idea of how much the business really is earning.

In the case of HMV, the analysts reckon on £33m in earnings next year. Say you reckon the costs of closing stores and re-invigorating the remaining ones will come in at £18m. And then you say to yourself, I reckon they'll need to pay back £15m to lenders... that's £33m! Suddenly there's nothing left for shareholders.

This adjustment to the PE that I've just described is also known as the Price to free Cash-flow ratio (PCF). You'll often find it quoted in the financial media. And it is a far more useful figure than PE. While it doesn't get around the old earnings pitfall - it's nearly always based on historical data - it does help you put the prospects of future benefits into sharp perspective.

Ultimately, you'll need to make your own assessment of the situation to get a more meaningful figure. That's where your skill comes in.

The important thing is to use your common sense to make adjustments to the earnings figure. That's what makes your valuation unique and important... just the same as when you're deliberating over baked beans.

How to use these techniques to beat the City to the real gains

Before I go today, I just wanted to mention a fascinating report sent over by Cris Heaton of Asia Investor. It's about some "Blacklisted Stocks" that he has found in Asia. Cris has a serious talent for valuation - he goes way, way beyond PE and PCF. And he has a habit of finding undervalued gems in Asia long before analysts take an interest.

I think he's uncovered a couple of serious stories here. It has to go to Cris' readers first. But he says he is happy for me to pass it on to Right Side readers - I'll tell you more on Friday.

This article was first published in the freeinvestment email The Right side. Sign up to The Right Side here.

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Bengt graduated from Reading University in 1994 and followed up with a master's degree in business economics.


He started stock market investing at the age of 13, and this eventually led to a job in the City of London in 1995. He started on a bond desk at Cantor Fitzgerald and ended up running a desk at stockbroker's Cazenove.


Bengt left the City in 2000 to start up his own import and beauty products business which he still runs today.