How to Value Tech Stocks

Why the P/E ratio can be misleading

Have you ever avoided a tech stock because it had a very high P/E ratio, only to watch it double or triple in price? Or perhaps you bought a tech stock because its P/E ratio seemed very low, only to see its price drop another 50%? If so, you're not alone. This is a common mistake among amateur investors who rely heavily on the P/E ratio to determine whether a stock is expensive or cheap and to guide their buying or selling decisions. In this article, I'd like to share the truth about P/E ratios and how to more accurately evaluate tech stocks.

What is the P/E Ratio?

If you take any investing or finance course, one of the first concepts you'll likely encounter is the P/E ratio, or price-earnings ratio. This ratio is calculated by dividing the current share price by the earnings per share (EPS). For example, if a company's stock is earning $1 per share and the current share price is $10, the P/E ratio would be 10. This means that for every $1 in earnings, you're paying 10 times that amount to purchase the share. Theoretically, if earnings remain constant, it would take 10 years to recoup your investment.

In basic finance courses, you're often taught that a low P/E indicates a cheap stock, while a high P/E indicates an expensive stock. Consequently, the advice is to avoid high P/E stocks and buy low P/E stocks.

However, in reality, this approach doesn't always yield positive results for investors. The P/E ratio can be misleading and an inaccurate measure of a stock's value. While the P/E ratio can be useful in some situations, it doesn't work consistently.

An interesting analogy compares using the P/E ratio to determine a stock's value to guessing a person's weight by looking at their shadow. A skinny person can cast a large shadow, and a heavier person can cast a small shadow, depending on the angle and lighting. Similarly, a stock with a high P/E ratio might actually be undervalued, while a stock with a low P/E ratio might be overvalued.

This is because the P/E ratio alone doesn't provide a complete picture. I'll illustrate this with an example to show why it's not always wise to avoid a stock just because it has a high P/E ratio or to buy one simply because it has a low P/E ratio. You need to consider other factors beyond the P/E ratio to make informed investment decisions.

P/E ratio can be misleading

Take Microsoft as an example. In 2018, Microsoft traded at $92 and had a P/E ratio of 61. Many investors might have avoided the stock, thinking it was too expensive. However, its price kept going up, and now, six years later, it’s up 400%.

But let’s look at the short term. In July 2023, Microsoft had a P/E ratio of 35. Again, some people said it was too expensive, but if you bought it at 35 times earnings, Microsoft's share price would be up 25% today. If you had avoided Microsoft due to its high P/E ratio, you would have missed out on substantial gains.

Conversely, a low P/E stock may not always be a good deal. Take Noah, for example. In 2019, it was trading at a P/E ratio of 11 with a share price of $22. Many might have thought it was a bargain. However, today, its P/E ratio has dropped to 5, and the share price has fallen to $8. This shows that relying solely on the P/E ratio to decide which stock to buy is not effective. The P/E ratio alone is pretty meaningless because it doesn't consider the quality of the business. Every stock represents ownership in a business, so it's crucial to ensure that the business is high-quality. Additionally, the P/E ratio doesn't account for the growth of the business's earnings.

So, the key takeaway here, echoing Warren Buffett's renowned advice, is that it's wiser to invest in a wonderful company at a fair price than settle for a fair company at a wonderful price. This principle underscores the importance of prioritizing high-quality businesses that are reasonably priced, even if they may command a slight premium, over opting for average or lower-quality companies solely because they appear cheap.

Many investors often fall into the trap of solely relying on metrics like low P/E ratios or recent price declines to guide their investment decisions. However, Buffett's wisdom reminds us that the quality of the underlying business is paramount. Simply put, a low-quality business remains a risky investment, regardless of how attractively priced it may seem.

Look at Free Cash Flow instead of Net Income

The P/E ratio can also be misleading because it relies on net income, which comes from the company's income statement after taxes. Net income is used to calculate earnings per share in the P/E ratio. However, net income's reliability can be questionable. It's often distorted by various accounting practices. Non-operating expenses, such as depreciation and amortization, aren't related to the core business operations. Also, one-time expenses or revenue items can affect net income. Non-operating income and expenses further complicate matters by reflecting income or costs outside normal business activities, which can give a skewed view of a company's financial position.

Let's dive into the example of Salesforce to illustrate this point. Salesforce has consistently grown its revenue over the years. However, if we examine their net income, which impacts earnings per share, it fluctuates significantly: from billions to millions and back again.

Currently, Salesforce's P/E ratio stands at 45, which is a prime example of a tech stock with a high P/E ratio that remains undervalued.

I've been buying CRM for many years. For instance, back in 2022, it was similarly undervalued. Many people thought I was mistaken, considering it too expensive with a P/E ratio of 460.

Now, why did I believe then and now that Salesforce is undervalued despite its high P/E ratio? The net income has been distorted by non-operating expenses and non-recurring items. Upon deeper analysis of the financial statements, you can identify restructuring costs related to mergers and restructuring charges, which significantly reduced net income. There were also losses on the sale of investments, which are non-recurring items. This all temporarily lowered their net profit and skewed the reported profit.

As an analyst, it's crucial to normalize this by adding back restructuring charges and losses on investment sales to get a more accurate profit figure. Or you can focus on free cash flow rather than net profit to have a better idea of how the business is doing without these one-time expenses.

My approach to valuing Salesforce

To determin Salesforce's true value, I employ the discounted free cash flow method which calculates the intrinsic value. Intrinsic value determines a company's worth by projecting future cash flows and discounting them to present value, accounting for the time value of money. This approach is crucial for assessing whether a stock is undervalued or overvalued.

Using my intrinsic value calculator, I consider:

- Projected cash flows for the next 20 years

- A discount rate to factor in risk and time

- Key variables such as total debt, cash reserves, and growth forecasts

For future performance insights, I recommend averaging growth rate projections from trusted financial sources like Finviz and Guru Focus. This rigorous method ensures a comprehensive evaluation.

The result: Salesforce’s intrinsic value is calculated at $320 per share.

Based on my analysis, Salesforce appears undervalued by 20%, despite its relatively high P/E ratio. This underscores the importance of looking beyond conventional metrics to determine a company's true investment potential.

Valuing companies through the discounted free cash flow method offers a clearer perspective than traditional metrics like P/E ratios. My success in beating the market comes from simply buying undervalued companies without listening to what the media or other experts are saying / predicting.

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Written by Timothy Assi, an Elite popular investor on eToro. Follow & copy my portfolio:

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