TRAP FOR INVESTOR: P/E

P/E-based recommendations barrage individual investors in dalal Street research reports and investment newsletters. A parade of money managers and analysts appearing on television say things like, "At next year's estimated earnings per share of Rs 2 and a P/E of 15, our target price is 30 -- a 25% increase over the current price"

Growth-stock money managers search for companies with rapidly rising sales and earnings that trade at reasonable P/E multiples. Value investors look for quality companies that trade at low P/E multiples.

Relying on P/E numbers is a prescription for disappointing investment results because earnings snapshots company hasn't yet received cash and exclude cash outlays for assets that it expects to generate future revenue, can be significantly higher or lower than cash flows.

Investors ignore risk if they look at earnings alone. Technology stocks with highly uncertain prospects are current year that account for virtually all of a company's value are excluded. For instance, earnings represent only 5% of the share price for a stock trading at a 20 P/E multiple. Where do you turn when a company has Though most analysts acknowledge these shortcomings.

Buying shares just because the P/E ratio is less than the expected growth rate is shooting in the dark. There is no economically meaningful relationship between the P/E multiple with its arbitrarily calculated "E" and the earnings growth rate projected over an equally arbitrary short period

Furthermore, despite growing earnings, companies may destroy shareholder value if their investments earn a rate of return below the cost of capital. P/E and PEG yardsticks are shortcuts, all right, but unfortunately they are also investment cul-de-sacs.
Focusing on the P/E multiple without considering the cash flow/earnings ratio can yield a seriously misleading picture of the market's growth expectations

There is another way. Cash flow -- revenue less operating expenses excluding depreciation and amortization, less investment in working and fixed capital -- is a much better measure of a company's worth. Without cash flow to fund growth and pay dividends, a company's shares are worthless. A company's value reflects its long-term cash-flow prospects discounted by a rate of return that compensates investors for risk.

Estimating the highly uncertain drivers of future cash flows -- sales growth, operating margins and investments -- can be time-consuming and difficult, so the P/E multiple becomes a shortcut. Instead of comparing the stock price with its discounted cash-flow value, the P/E ratio compares price with an estimate of a company's earnings for the next year or the past year's reported earnings.

Among the cash-flow drivers, changes in sales-growth expectations typically have by far the greatest impact on stock price, so that's the most productive place to start the analysis. Sales-growth revisions not only affect value directly but also trigger changes in operating margins via economies of scale and the spreading of fixed costs over greater or lesser volume .

When analysts use P/E ratios as their valuation benchmark, they often do not make explicit the assumptions underlying their forecasts. It is ironic that at the very time investors demand greater transparency in corporate financial reporting, they continue to tolerate opaque stock research reports.