Intro to Fundamental Analysis: What's Wrong With the P/E Ratio?

Far too often, the relative attractiveness of a stock is discussed in terms of its price-to-earnings ratio (P/E Ratio). This is an inherently flawed method for determining a stocks value; although the "P" portion of the equation is an objective fact at any given point in time, the "E" is exceedingly more suspect in nature. For those new to this, "P" is the price of the stock, and "E" represents earnings, or net income. To keep things simple, suppose you have a $10 stock, issued by Company X. Let's also say that Company X has earned 25 cents/share each quarter of the past year, and it projects earnings of 25 cents/share for each of the next four quarters. In this situation, Company X will earn $1/share this year. Therefore, at a share price of $10, the stock is trading at 10 times earnings, or a P/E Ratio of 10. Note: Some investors like to use a forward P/E ratio, which basically looks at the next four quarter's worth of estimated earnings to determine the "E". Other fans of the P/E use trailing earnings to calculate the denominator; in other words, the sum of the four most recently reported quarterly per share earnings. I purposefully fashioned my hypothetical Company X earnings report such that both the forward and trailing P/E ratios are 10. This doesn't happen in real life.

Now that everyone is hopefully up to speed, I can get into the real issue here: What's wrong with the P/E ratio? Well, as I said before, the problem is with the "E" or net income. In small business, net income - or more commonly "profit" - is simply the cash left over after you pay the bills. It gets a little more complicated with publicly traded corporations, all of which must adhere to Generally Accepted Accounting Principles (GAAP). Under GAAP, the quarterly income statements that all corporations must file include, and in some cases are dominated by, non-cash items. Let's say a company purchases a tractor for $10,000. Fast forward one year, and the company has accumulated say $900 worth of depreciation on the tractor. That $900 will be recorded as an expense on the income statement, reducing reported earnings despite there never being a $900 change in the company's cash position. As a contrasting example, consider a company that extends credit to a large customer on December 20th, selling $1M worth of software. The seller's assets will increase by $1M via a debit to accounts receivable, and revenue will increase by $1M. Assume that the terms of the sale on account dictate payment within 30 days. For the year ended December 31st, that company will report the $1M as revenue, although they probably won't have received the cash yet.

A further earnings distortion occurs based upon the quarterly price fluctuations of balance sheet assets the company lists as "marketable securities". Often times, a company will use surplus cash to invest in other company's stocks. The change in market value of these securities, whether or not they are actually sold for a profit (or loss), will be recorded as income (or loss) on the quarterly income statement. Obviously, these items are neither indicative of the company's operating performance, nor indicative of changes in its cash position.

Hopefully, by now all readers are appreciative of the reality that a corporation's reported net income is a fickle beast, and that it should not be trusted. Therefore, any ratio whose entire denominator consists only of "net income" should be viewed through a skeptical lens. Don't worry though, as this post is only the first part of the Fundamental Analysis series. Future posts will help investors develop a more holistic and accurate approach to stock analysis and valuation.

Next up in the series: Cash Flow From Operating Activities (CFFO) to Net Income Ratio Sphere: Related Content

No Reason to Cheer Intel's Earnings

The predictably upbeat reception that was held for Intel (INTC) following the Company's Q2 earnings release, after hours yesterday, featured the well-told storyline that the economy has bottomed, and prosperity is just around the corner. To it's credit, Intel has managed to operate efficiently throughout the recession, reporting a quarterly revenue decline of only 15.2% compared to the same quarter in 2008. They've also taken the EU fine in stride, booking the $1.45B charge for Q2 and moving on. However, we take issue with any attempt to characterize these results as indicative of a pending turnaround in the Broader Economy.

First of all, to reiterate one of our common themes, Intel was able to "surprise" analysts through a combination of "less bad than expected" sales and, very importantly, across the board reductions in operating expense. Obviously, any comparison to Q2 '08 must take into account that oil was priced at ~$140/bbl; exerting upwards pressure on ANY petroleum based product. In addition to the cost-of-goods benefits, Intel clearly made the decision to trim it's marketing/G&A and research and development expenses. Compared to Q2 '08, these expenditures declined 12.5% and 11.2% respectively. Across both categories, these percentages represent cost cuts totaling $345M. This is important considering that one of the key figures cited by bulls as "surprisingly good" was the Company's Q2 gross margin percentage of 50.8% - a handful of percentage points above stated guidance of "mid-40-ish". This "surprise" is more than explained away by the substantial reductions to operating expense.

Secondly, the reaction to INTC's results shows the ability of economists to spin just about anything. For the past several months, economists have espoused the view that according to official inventory figures, the economy in general should benefit from a "re-stocking" effect in the second quarter as companies re-stock their barren inventories with new product. Surprisingly though, as soon as the oft-cited inventory dynamic begins to appear in corporate earnings reports, we are supposed to believe that this new demand is being driven solely by a stabilizing economy. We certainly aren't buying it.

*no position in INTC

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Alcoa's Loss Inexplicably Satisfies the Market

Alcoa, after losing 59 cents/share in Q1, "swung"(why is this term used so often) to a Q2 loss of either 47 cents or 26 cents/share, depending upon what one chooses to include in a calculation of loss. We would also note that the flurry of articles published post-announcement tended to preface the losing results with the term "only"; as if to give consolation to the fact that the Company failed to fulfill it's only purpose for existence: turning a profit. The company's revenue was only up 2.3% from the first quarter, indicating that the earnings "improvement" was simply a result of cost-cutting. Alcoa's President/CEO Klaus Kleinfeld had the following to say:

"Our cash generation initiatives, productivity improvements, and portfolio changes are working"

Translation: we cut costs through firings and reductions to employee's hours. As evidenced by the included chart, Selling, General and Administrative expense has been reduced substantially over the previous 5 quarters. However, because the media tends to fixate on Positive second derivative movements, we'd like to point out that Alcoa's cost cutting has declined in it's acceleration; setting the stage for flat earnings in the quarters ahead. Of course, if you are bullish on automotive sales and new housing construction - two industries upon which Alcoa relies heavily - then further cost-cutting should not be an issue for you. We are not bullish on these two areas of economic activity however, and contend that Alcoa's cost cuts will have to increase on an accelerating basis in order to continue to report Street-Acceptable earnings "growth". We would also propose that this dynamic can be applied to the majority of the corporations that comprise the S&P 500 index. Needless to say, while cost cuts may bode well for the bottom line, they do not stimulate the economy.
*no position in AA

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Reaction to FedEx Indicative of Market's Excessive Optimism

Shortly after FedEx, the global shipping company, released its results for the recently concluded quarter and provided guidance for the current quarter, a spate of explanatory headlines were generated and distributed across the usual media outlets. According to the reports, Wall Street was most focused on the current quarter's guidance (forward looking bunch they are), and what said guidance from the "bellwhether" company means for stocks and the economy going forward. We noted that "cautious" and "downbeat" seem to be the adjectives most commonly deployed in the overrall attempt to characterize the Company's current quarter forecast, which estimates earnings of between 30 and 45 cents per share v. analyst estimates of 71 cents per share. Earnings within the estimated range would correspond to a quarter to quarter decline of at best 19.6%, and at worst 53.1% based upon last quarter's 64 cents per share (ex items) of reported earnings. The fact that Wall Street is disappointed at this guidance is, we believe, indicative of the excessive Market optimism that has contributed to the current over-pricing of US equity markets.

The Market, choosing only to remember recessions that follow a "V" shaped progression, is naturally forward looking and anticipatory of quarterly earnings Gains. The fact that the broader market is trading at a multiple of greater than 20X reported earnings is irrelevant to many. The logic of the "V" shaped recovery supports the conclusion that the Market is only expensive based on Current earnings, and that as earnings rise in the quarters ahead, prices will increasingly be supported by the underlying earnings. The important distinction we see is that while the financial crisis has abated, there is still a considerable degree of weakness in the US economy as a whole. The United States continues to shed jobs at a rate that, while not indicative of a literal collapse in economic activity, would certainly be considered damaging. Furthermore, the rise in oil prices has rendered meaningless a substantial portion of the cost-cutting that nearly every company has been engaged in.

The primary lesson from today's "guidance disappointment", we think, is that there is no substitute for a common sense approach to investing, especially with regards to an individual investor's participation in the US equity markets.

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