The widespread use of the PE ratio by investors to assess and compare the price of stocks is a product of the investors fixation and tendency of investors and analysts to focus on the income statement and earnings growth.
This is, however, largely misguided. As a CPA and ex-auditor, I can speak with some confidence as to the amount of management judgement that goes into the treatment of different expenses. The decision to capitalize or expense a cost, for example, is a big one. While statements are of course audited, this is by no means an assurance (no pun intended) as decision are still based on reasonable judgement and open to error.
Furthermore, the quality of earnings is a fundamental factor on the quality of a business. Not all earnings are equal. For example, are earnings being funded by debt or by equity? It is easy to take on large amounts of debt to fund earnings growth despite this potentially being value destructive to shareholders. Another fundamental question as to the quality of earnings, is the conversion of these earnings to free cash flow available to shareholders. Some businesses have particularly high maintenance capital expenditure requirements, like airlines. That means that even though earnings may be increasing, the business is not able to generate meaningful returns for shareholders because a large proportion of those earnings must be reinvested into the business, just to maintain it’s current operations.
Given the choice between two businesses with the same earnings growth and potential, the investor should be prepared to pay materially more for a business with stronger FCF conversion (FCF / Net Income or EBITDA) on those earnings.
Connections
Capital Cycle Purchase Candidates
Link Explanation: The linked note explains how there are two different kinds of candidates for investment purposes under the capital returns methodology. The key is that under both circumstances, the earnings quality, or the ability for the business to generate cash over a long period of time is the fundamental driver of what makes a business good. The connection with this note is that the price to earnings is not the metrics that should be used to assess the quality of the business, but P/OCF or P/FCF, depending on the type of investment being assessed.