Q&A: The Complete Picture of a Company's Value
Each month, we break down topics
related to value investing.
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If the intrinsic value of an asset at a single point in time is only part of the picture, how do you figure out the rest? Some approaches to value investing seem to lean heavily on formulas and metrics, like price-to-earnings (P/E) ratio, for example. Is that enough to give you a complete picture?
Short answer: no. Those kinds of metrics can be helpful, but they’re incomplete, and I don't screen companies based on that. I'll give you a multi‑pronged answer as to why.
To start, it's too easy, and the metric itself is just a snapshot. I'm looking to understand where earnings are going in the future. If we’re driving, we might glance occasionally out the rear-view mirror, but we need to be focused out the front window. In other words, if everyone's screening off price earnings and it's telling us about the past, the idea that you're going to have massive mispricing is very, very low.
Another issue is that kind of metric is going to lead you to companies where earnings are relatively stable. That’s not necessarily bad! But it’s not necessarily good either. Some of my best ideas screen poorly based on price earnings. Let's say it's a cyclical company, where earnings happened to be very, very low but we know that in the next two or three years earnings will accelerate because of a cyclical rebound. Well, that company might screen poorly based on P/E ratio, but you know that over the next two or three years, earnings are on the verge of exploding. That's one reason why it's overly simplistic.
Then, remember that every company that goes bankrupt eventually looks cheap based on P/E ratio. Very few companies that are tomorrow's leaders ever looked "cheap" based on historical measures. I do think that you can't have just a quantitative approach without trying to marry it to the underlying business quality. Valuation is important, but assessing the business itself on a lot of qualitative factors is also very, very important.