A commonly used thumb rule in investing is that a company selling below a PE of 10 is likely to be cheap and one above 30 is likely to be expensive. I have been guilty of using this rule, often subconsciously and have paid a heavy price for it.
To see the example of a PE driven investment gone wrong, read the analysis of Facor alloys here. In a year’s time, I realized that I had made a mistake and exited this position with a 12% loss – you can read my analysis here. If I had held on to the position, I would have lost close to 85% of my investment, even as the stock continued to sell at a very low valuation (current PE being 3)
Reasoning from first principles leads one to understand the fundamentals factors driving the issue in question. So how do we apply this concept to investing?
Quite simply, the one absolute and immutable fact of investing is that the value of an asset is the sum of the discounted free cash flow, it will generate over its life time. The above statement does not mean that an asset cannot sell above or below this value from time to time, but anyone holding an asset over its life time, cannot make more than the cash flows its generates over this period.
Lets break the above point down into its key components
– Free cash flow
– Lifetime
– Discounted
Free cash flow – Can be estimated as follows : Gross rent – taxes – maintenance expense – other overheads
Lifetime – This is the period an asset can be expected to generate a cash flow. In case of a flat or house one can take as it as 30 years, before one has to permanently replace it with a new construction. In an extreme condition you can stretch it to 50 years, however try letting out a very old house and you may realize that the rentals are much below the market rates.
So how would you value the house or flat now?
The gross rental yields these days are usually around 2-3%. At these yields , one is in effect paying 50 times pre-tax free cash flow. This of course assumes 100% occupancy and no taxes.
If you put all these cash flows together and discount it at around 10%, the final DCF value comes to about 1.5X purchase price. In other words, the asset is generating an IRR of 12%.
The problem with PE ratios
As you can see from the above example, the PE ratio is dependent on several variables which we had to estimate upfront. In the case of some assets such as a rental property, it may be possible to estimate it with a certain level of confidence.
Let say, for the sake of example, that the house turns out to be on an old burial ground where there are ghosts and so one want to rent or buy that land J . What happens then? Well the entire investment goes to zero.
So the initial PE turns out to be cheap or expensive depending on the subsequent cash flows and terminal value of the asset
In the case of companies, the problem we face is that the cash flows are quite difficult to estimate, there is no fixed duration and the terminal value in the real long run for any business is usually 0.
The above assumption turned out to be wrong. The cash flows were at a peak due to a cyclical high in demand from the steel industry. In addition to a crash in the demand, the management diverted the cash flows to another sister firm which demonstrated poor corporate governance.
As a counter example, consider the case of CRISIL(a past holding) which has always appeared expensive based on the usual measures of valuation. However the company has delivered above average returns as it has generated the expected cash flows without much variability in a fairly predictable fashion. The competitive position continues to improve and the company is likely to keep growing with a high return on invested capital for the foreseeable future.
The only way to evaluate if a company is over or underpriced is to be able to predict its cash flow. The higher the valuation, the longer the prediction period.
On the flip side, if you are looking at a company selling for 100 times earnings, one needs to have a high degree of confidence on the expected cash flow for 20+ years and beyond. Anyone claiming such clairvoyance is worth of worship !!
In summary, the best way to approach an investment candidate is to filter out the extreme cases and then dig into the business as much as possible. This should help one make a reasonable estimate of the cash flows and its duration. Once you have a reasonable fix on these key inputs, doing a valuation and comparing it with the market price is the easy part.
It is selling for 10 times earnings net of cash for sure. Personally I think the PE ratio here is meaningless. One is making a bet that Coal will continue to be a dominant fuel for us for the next 10-20 years in face of dropping cost of solar and other energy sources such as Natural gas. In addition there is also the headwind of climate change regulations and drop in prices globally. In short I don’t know enough to predict the cash flow and hence the idea is a pass for me. If you plan to buy or hold it, you need to answer the above questions with a high degree of confidence.
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.
