Price/Earnings (P/E) ratio.
A company is priced at $50 in the market, it earns $2 per share annually. Its P/E ratio is 25 = 50/2. Here’s a cool trick: the inverse of the P/E ratio is also the Internal Rate of Return (IRR) of the enterprise. So 1/25 = 4%. That can then be compared to the existing bond market returns to decide on asset allocation. If you are a classic value investor this will be the primary decision criteria.
The faster company earnings are growing, the higher P/E ratio a company will support in the market because you are purchasing future returns, not just today’s. (note: too many investors think they are investing in the current status of a company. This includes startups. No!!! You are investing in the future. The current value was financed by investors already in the deal. You are ALWAYS investing in the future potential, not the present value.) A utility with low earnings growth might have a 10 P/E = 10% IRR. A speculative company with high earnings growth supports a 50 P/E = 2% IRR. Easy!
In an ideal efficient market, global investors analyze a company, look at the present earnings and create a viable model for the growth of future earnings and then apply a P/E model that results in an expected future value of the company. We discount this using the current interest rates to the present day and decide the company should be worth $60. Theoretically, this is how Wall Street analysts set price targets. Given the ACTUAL growth numbers are not knowable we must assign a range to the future earnings leading to a range of potential price targets.
But this model widely used by EVERYONE in finance is missing an important component. And because erstwhile professionals forget this, they also make serious mistakes in decision theory.
Here is the PROBLEM. Using P/E ratios to define Growth vs. Value assumes the current market value of a company fully encompasses why the company is priced at $50, or whatever. Efficient market theory states this explicitly, but professional investors know that if that were true, then everyone would receive the exact same investment returns. So let’s look at HOW companies become growth vs. value stocks.
An alternative definition.
Growth vs Value stocks are a misnomer; most stocks are a mix. You have present earnings and an expectation of future growth. The greater the growth projections the higher the P/E ratio that can be supported. In fact the S&P 500 growth index has ~240 names and the value index has 440 names. For a total of 680 companies in the 500 company index. The index creators KNOW that most companies are some mix based only on this type of criteria.
Instead, imagine a stock is priced by two different criteria. Popularity (or Speculative fervor) and Operational delivery. Some stocks catch the public eye and investors buy it because they think it is cool or they like the product. One need not look further than meme stocks to see the truth in this. But AMC Theaters and GameStop behaviors are not new or unique. Once upon a time, Crocs footwear, the Cigar Store and Krispy Kreme were all meme stocks (we called them “cult” stocks – “meme” being a decidedly new millenial word). I’ve discussed the idea of the Keynesian beauty contest before. Quoting from a prior blog:
Economists call it the “Keynesian Beauty Contest” where judges are rewarded for selecting the faces chosen as most popular among all judges, rather than those they may personally find the most attractive. Think of it as gambling on who the audience will pick for America’s Got Talent. It is a valuable way to view the financial markets with healthy skepticism, but not particularly informative for good investing.
Cult and meme stocks rely on this. It is the underlying rationale that drives the greater fool theory and leads to speculative excess. It is why speculation is driven faster in bull markets and faster still when monetary conditions are loose.
There is always someone more foolish than I: “Yes I know the company may not be worth $50, but someone else is likely to buy it from me at a greater price.”
It also explains why the most speculative assets are highly sensitive to rising interest rates. But that is a topic for another day. Let’s revert back to the primary topic.
Imagine the alternative: put yourself in Warren Buffet’s mindset. “Would I own the entire company at this price?” NOTE: this is not the Elon Musk version – “I’ll buy Twitter at $54.20 because it’s funny and I like to piss off the SEC with my tweets.” This is all about cash flows and growth opportunities. And there’s the payoff…
The REAL dividing line in stocks is:
Speculative: I am buying this because I think it will go up and I’ll sell it to another “Greater Fool” before the music stops.
Ownership: I am buying this because at the current price I would (if I had the means) own the entire company as a private entity at the current price.
At first blush, the correct decision is obvious; we would all choose the second reason. But the reality is that most “growth” stocks as discussed in forums online, or even on CNBC, have a large contribution of the first. Would it surprise you to know that 90% of V/C decisions actually get made based on the first criteria? Early stage companies depend on financing, so V/C’s, and other early stage investors, may talk the talk about management and Total Addressable Market (TAM) etc., but most gravitate to “Blockchain, blockchain, blockchain”, or Electric Vehicles, or whatever may be the hot trade of the day. Just watch the trends, and see what companies get funding, and you’ll also know that the bulk of V/C funding simply flows with the speculative trend of the moment.
On the other hand, the work that we do, the work that a good angel investor should do, is to analyze the product, the need, the actual company fundamentals, and decide – “Would I own the entire company at that price?” If you are reading this blog, it might mean I’ve been preaching to the choir. But just know: we do not buy lottery tickets. Hope is not a strategy; and when looking for growth stocks for your portfolio, don’t bet on what everyone else will be buying next season.
This blog could easily be a topic for a longer discussion round-table. If you would like to learn more please email me at michael.schmanske @ angelmd.capital. (I am also writing this while battling a little case of Covid…so pardon any incongruity.)