This post was shared with newsletter subscribers last week (August 15th):

Preface

Yesterday we were talking to the current forward PE for the S&P 500.

Based on Factset’s expectations for earnings of $140 per share – the market is trading at a PE of around 17.6x

We argued it was neither cheap nor expensive.

Will the market deliver $140 per share this year?

It might fall short or it may exceed it. If the past is any guide – it will probably beat it by a strong margin.

Now on the subject of PE ratios – this morning I read this (poor) article by Ryan Dinse at Money Morning Australia.

In short, Ryan was warning us about investing in high PE stocks (in this case Dominos) and how investors are potentially setting themselves up for massive risk.

In some cases that might be true… but in plenty of other cases it’s outright false.

As I say – Ryan’s poster child was pizza operator Dominos which apparently traded for a PE of around 37x… however after missing expectations fell something like 20%.

He then indicates a better bet is to buy a (slow growth) stock like Yum because it’s PE is 19x (suggesting there is less risk).

Again, that may or may not be true.

But here is where he really falls flat on his face – and demonstrates his lack of understanding around how to evaluate growth stocks. First up – take a read (bold emphasis my own):

The US Nasdaq has companies with some of the highest PE ratios on any market. That makes sense for a technology index. The companies here are creating products that — if they succeed — can grow at super-fast rates.

But exponential growth rates can’t last forever.

There are only so many markets, so many customers and so much shelf life a company can have. And unless you are Google [NASDAQ:GOOG], most companies will have to compete with newcomers and competitors constantly.

That means PE ratios have to fall, eventually.

And if they fall in this market, the falls could be spectacular.

Take a look at Amazon [NASDAQ:AMZN] for instance. It’s trading at a PE ratio of 185. Or what about Netflix [NASDAQ:NFLX]? It’s at a whopping PE ratio of 221!

Tesla [NASDAQ:TSLA] and Snapchat [NASDAQ:SNAP] aren’t even making any earnings to have PE ratios. At least, not positive ones…

Yet Amazon is valued at US$60 billion and Snapchat at US$14.6 billion.

Though in Snapchat’s case, the share price is coming down hard for the same reason that Domino’s share price fell. Optimistic expectations are not being met.

With no profits, the falls can be even more dramatic when investors lose faith in the growth story.

Where to start?!

First up Ryan, Amazon is not valued at a (tiny) $60B (or just 4x Snapchat).

I think you will find that Amazon is valued at something closer to $472B (with the share price at $982 at the time of writing).

But hey – what’s the difference between $60B and $472B. Just saying.

What’s more important is Ryan is focusing on Amazon’s PE ratio of 185x (and lack of profit).

According to his logic – you are setting yourself up for extreme disappointment (and risk).

But are you?

Further to that, he makes the comment that the likes of Tesla and Snapchat don’t even make money – therefore do not have positive PEs (again illustrating a lack of understanding).

Let’s start to unpack some of this (flawed) logic…

Does a Stock Have to be Profitable?

In short, the answer is no.

Not at all.

In fact, I wrote about this here (all the way back in Jan 2015 when I was telling folks to buy the likes of Amazon) and why their business model (and valuation) made sense.

Allow me to repeat a portion of that post for newer readers:

Today Amazon produces little or no profit (nb: it’s still the case over 2 years later).

And whilst most analysts (and Amazon competitors) love to point out this fact (no different to our friend Ryan who is focused on a PE of 185x) – this is a deliberate decision from one of the best CEO’s in the business – Jeff Bezos.

For example, read this article on why Amazon has chosen this path. I quote:

“… we have dozens of separate businesses within Amazon, and over two million third party seller accounts, all sitting on top of the Amazon fulfillment and commerce platform. Some of them are mature and profitable, and some are not. And someone at Amazon has the job of making sure that each quarter, this nets out to as close to zero as possible — at least as far as net income goes.

That is, the problem with net income is that all it tells us is that every quarter, Amazon spends whatever’s left over to get the number to zero or thereabouts. There’s really no other way to achieve that sort of consistency”

If you read closely, Amazon itself tells us this.

The image below comes straight from Amazon – originally it was a napkin sketch by Jeff Bezos. Note that there’s no arrow pointing outwards labeled ‘take profits.’ This is a closed loop.

Great business model!

Profits as reported in the net income line are a pretty bad way to try to understand a business like Amazon, Netflix, Google etc — actual free cash flow is better.

As the saying goes, profit is opinion but cash is a fact.

Amazon itself talks about cash flow and not net income (Enron, for obvious and nefarious reasons, was the other way around).

Bezos deliberately focuses very much on free cash flow (FCF), but it’s very useful to look also at operating cash flow (OCF), which is simply what you get adding back capital expenditure (‘capex’).

Focus on Free Cash Flow – not PE

If you invest like our mate Ryan – you are never going to catch the next Amazon, Facebook, Google, Netflix or Apple.

You might invest in Johnson & Johnson, Qantas or maybe even a bank…. but not a stock growing at more than 20% per year.

You just wont see it because you have the wrong lens.

For example, typically you will take Ryan’s “PE’s are above 30x are too risky” model and act like a deer in the headlights.

Too expensive. Next.

As an aside, I know some experienced investors that won’t buy the Index because the PE is above 15x!

It’s been above 15x post 2008!

Say goodbye to the second largest bull market in history. I digress… best wait for the next one.

Now when I tipped Amazon over two years ago – it was trading at ~$300 a share. Today you are up 300%.

And guess what – back then its PE was negative!!

But it’s cash flow was phenomenal and growing (as was its customers and revenue).

As an aside, Warren Buffett was asked at his most recent conference why he didn’t by Amazon two or three years ago.

His answer? Stupidity.

As far as I was concerned, Bezos didn’t need to make a “profit” for another 10 years… just keep that cash machine (and more importantly innovation) singing.

And he has… in spades!

A company’s free cash flow (or FCF) is one of my favourite metrics when evaluating any stock – not necessarily the ‘holy grail’ called net income (and the basis of PE’s).

Microsoft Example

Two years ago I also tipped readers into buying Microsoft around $45 per share.

Today it’s above $70.

My logic was the same – cash flow.

When I looked at Microsoft — all I could see was a cash machine spitting out money.

What I told readers at the time was looking at how soon the company can buy itself outright using just its free cash flow.

The sooner it can do that… the more it can reinvest in the business or acquire other businesses (leading to further growth).

And look what they did…. the gobbled up LinkedIn.

At the time, MSFT was trading at a PE of around 16x. Not cheap. Not expensive either. Again, not a metric I was too bothered with.

But what about the price opposite its cash flow?

Much like earnings – a great measure is the stock’s cash flow as a function of its price.

Earnings are often manipulated by clever corporate accountants… however cash flow rarely lies. Doing this also removes the effects of depreciation and other non-cash factors.

Calculate this figure by dividing a stock’s current share price by its cash flow per share.

At the time, MSFT’s price to cash-flow ratio was a super-low 12.4

Put another way, it was trading a decent discount (5%) to the markets’ value of around 13x.

The Buyout Ratio

Impressed with the numbers — I also decided to apply one more litmus test…. something I call its “buyout” ratio.

For the purpose of clarity — free cash flow is the cash left over after a company has paid its business expenses and set aside cash for future growth.

For you as an individual – you might call this your discretionary income; ie what’s left over after your mortgage (or rent); your taxes; insurance costs; medical bills; food, transport; utilities; school fees etc etc.

For most Australians today – this is essentially zero!

For example, for someone on $150K per year with a mortgage of $500K; 2 kids in school; a car… it might be $10K per year (at most).

For a business – to calculate free cash flow, take cash flow from operations and subtract capital expenditures.

But what I am really interested in here is what FCF represents as a ratio to the total valuation of a company.

This is more comprehensive as it takes into account a company’s cash and debt position… and then measures how many years of FCF it would take to buy the company outright.

The lower the ratio, the faster the company can generate cash and reinvest in the business. For MSFT – this was a very attractive 12x.

As a rule of thumb – anything at 12 or below is excellent – particularly for a quality company like Microsoft. This tells me that the company could buy itself with 12 years its free cash flow (when it’s price was below $47 per share).

Now, back to our individual example (ie the person with $150K annual income and a $500K mortgage (average for those in Sydney).

Imagine you could pay off your entire $500K loan within 12 years of just discretionary income?

You would need to have discretionary income of around $50K per year (factoring in interest payments). Again, that’s what’s left over after all your expenses! Some of you say “I wish”!

That showed me how cash rich MSFT was. I could not care less about its PE!

Free cash flow machines are typically very good businesses.

Putting it All Together

PE ratios are often used by ‘funnymentalists’ to try and justify the valuations on companies (and/or markets).

And maybe for very old, established business they hold some weight.

But I’ve never really been a fan.

As I say, apply this model to say a Google, Facebook or Amazon the past few years, you would have never invested.

Where has that left you?

Perhaps holding some “sub 15x PE” stock like Yum (which Ryan references) that was $52 in 2011 and is $72 some 7 years later (ie a little of 2.5% per year).

At least it beat inflation (just). Pffft. No thanks.

For the purpose of clarity – not all high-flying PE stocks are good. There’s a good number of bad-eggs out there waiting to destroy your cash.

For example, I don’t like Snapchat… I would much rather by Facebook. Facebook has a great business – generating a ton of cash.

You need to do your numbers (and/or trade the tape). Again, look at their free cash flow and their net position of debt.

But using Amazon as a ‘poster child’ for potential disaster because:

(a) it barely makes “profit”; and/or
(b) has a PE of 185x 

Sorry.

To me that just highlights a genuine lack of business acumen and understanding.

… trade the tape

When investing in shares, you can lose you some or all of your money. The potential gains on my blog are based on investing in Australian and US markets and don’t include taxes, brokerage commissions, or other fees. It’s important you seek independent financial advice regarding your particular situation. For any investment, never invest more than you can afford to lose, and keep in mind the ultimate risk is that you can lose whatever you’ve invested. If in doubt – always seek independent financial advice.

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