Question: how come some low p/e stocks that maintain or grow earnings don’t produce anywhere near the results their p/e would suggest?

[billcody]

The main example of this are car makers (oil, utilities, shipping might also be examples). These car makers in the long term maintain or grow their earnings, yet you could have bought them many years ago at a p/e ratio of 5, and with dividends reinvested would have gotten like 10% per year, not 20%+ as the p/e ratio would suggest.

After all a company with constant earnings at a constant p/e ratio of 5 should get you 20%. My economist dad says there’s no way that’s possible, but we can see it’s true that many companies as mentioned above break this eule routinely in a major way. Some mention the heavy need for capital, but that should be long term redlected in earnings, as the investments are written off. (According to my father).

Is it explained by them spending money badly?
That doesnt make sense as they could just pay dividends.

Can any smart people explain how these companies can maintain low p/e ratios in the long term?

 

[pastorjeremylove]

@billcody PE doesn't include all capital expenditures. Some industries, like cars and utilities, constantly have to reinvest in their equipment. So Warren Buffet recommends Owner Earnings: https://en.wikipedia.org/wiki/Owner_earnings

Maybe it's because capital expenditures aren't flat as these companies grow, so even over the long term, you're constantly putting more into capex and writing off what you invested in capex years ago, when the company was smaller?

 

[esper]

@pastorjeremylove Interesting. I didn't know PE doesn't account for capital expenditures. Weird if you think about it. Buffett was right to come up with a different metric.

 

[gallon6341]

@esper Buffett didn't come up with a different metric he just recommended it.

Best not to idolize even the goat.

 

[billcody]

@esper PE does account for capital expenditures by assigning a «fair» value to your expenditure and decreasing the value with time. Meanwhile free cash flow and such regards a capital expenditure as a waste of money when it isn’t, but on the other hand it should lead to higher fcf in the future. So really both should be pretty much equal in the long term? And fcf is unfair based on high vs low investment, while earnings is fair unless there’s something wrong with the valuations of something?

Idk that’s how i understand it, could be wrong.

 

[billcody]

@pastorjeremylove Aren’t these CapEx given a fair value, that then gets depreciated as an earnings loss? Shouldnt they be reflected in earnings?

 

[pastorjeremylove]

@billcody I think you're right, but that's still a huge difference. Let's say a company has 150k in earnings, and goes out and buys a bulldozer for 150k and depreciates it over 5 years. The next year, you're only going to see a 30k reduction in earnings, so it looks like the company had a total of 120k in earnings for the year. But in reality, their bank account might not have changed. And then if the company is constantly cycling through equipment, or buying new stuff, then there's going to be a gap between the PE and the real profit generated over the long term.

 

[cravinmaven]

@billcody The company's book value and stock price are 2 different things. It's possible the company gains book value but stock price doesn't necessarily follow because people are not interested to buy the stock at higher price, can be for a lot of reasons (less expectations). So company earns 10 million, but market cap doesn't go up by 10 million.

Even if stock price followed book value exactly, the company can lose book value: estate lose value, stuff get damaged, buildings explode. So if the company earns 10 million, but its estate lost 10 million in value, the company book value remains the same.

 

[billcody]

@cravinmaven Don’t feel like this answers my question well. Earning is the main driver of the stock price isn’t it?

And if their building blows up that should be reflected in earnings and they would earn nothing in your example i’m pretty sure.

 

[cravinmaven]

@billcody No. The price is what the market decides the price is.

A building blowing up is not reflected in earnings. What's reflected in earnings is a building being amortized (the years following its purchase).

So if you have a company that owns only 1 building that's worth 1 million, it's 30 year old so fully amortized. The building is useless to the activity of the company, it's just an asset not used. It explodes. The company loses 1 million in book value and doesn't lose any earnings.

 

[billcody]

@cravinmaven Yes, a loss in book value (from a building blowing up) is reflected in earnings. https://www.investopedia.com/terms/b/book-value-reduction.asp#

That building you mention if it’s fully amortizised it would have no book value. If a building has a real value but no book value that would be an error in the accounting.

 

[cravinmaven]

@billcody I was confused in my use of book value term, but the principle still stands.

In my country at least, assets very often have a different real value than their amortized value. It's not an accountability error here. Amortization is decided at the begining and is often much shorter than the real life of the object.

 

[salamseh]

@billcody You can do quite a bit of financial engineering with the earnings number and what you consider as investments.

That's why a lot of folks over at valueinvesting recommend long term p/fcf. The numbers might fluctuate more in big investment years, but over time, it gives a good idea.

Crosschecking how earnings relates to fcf gives a better impression if the money is just spent to keep the business running.

 

[billcody]

@salamseh Hmm my economist dad says you can only engineer earnings in the short term, not the long term. That makes sense to me. So how come some companies have very low p/e’s long term?

Won’t that CapEx be depreciated as earnings loss? So if they need so much capEx it will harm earnings.

 

[barcer]

@billcody A low PE ratio suggests that there is not a huge price premium per dollar of earnings because the future cash flows are not expected to grow wildly.

The P/E doesn’t say anything about expected returns.

They maintain low P/E because the companies hve matured out of the growth phase.

 

[cantur]

@barcer In a minimal growth company, with no changes to P/E, your returns should roughly equal E/P. So yes, it should describe your expected returns.