Sven is a burly German with a reasonable size ranch at the bottom of Eagle Mountain Lake, where it empties into the West Fork Trinity River. Once a month his wife cooks us a mean stew. While we wait for supper on the porch, we knock back a shot of peach schnapps every so often. There is a large peach orchard behind the house, but I never saw Sven or his wife eating a peach or peach jam. However, there is always a trunk under their bed filled with bottles of peach schnapps. Sven will never let you leave without a bottle in the saddlebag. He will never hand it to you personally but, rest assured, as you ride off there will be bottle in your saddlebag.

Sven?s cousin Hermann lived in Ulm, Germany in the late 1800?s. Hermann later moved to Munich, where he set up a small electrical business with his brother Jakob. Unfortunately, the business went under and the family moved to Milan. Hermann?s son Albert was a bit of a problem child. Albert was always in trouble at school. Asking impertinent questions, arguing that the teachers didn?t know what they were talking about and simply not respecting them. Eventually, Albert got a job in Bern and started writing about how he thought things worked in the world. You see, at the time people believed that space was not a vacuum but filled with a medium called ?ether?. People believed that light and radio signals were waves in this ether, just as sound was pressure waves in the air. The Jefferson Lab at Harvard University was built without one single iron nail because they thought the iron would cause magnetic disturbances. This would interfere with the efforts to measure the behaviour of light and radio signals as they travelled through ether. Funnily enough, Harvard?s buildings (including the Jefferson Lab) are mostly red in colour. This comes from the high iron content in the clay the bricks are made from. They might as well have conducted the experiments in a metal container!

What?s important to us is that that Hermann Einstein?s son, Albert, became famous for disproving the paradigm of space being filled with ether and establishing the theory of general relativity.

Now, this is clearly distinct from the theory that, ?to a man with a hammer, every problem looks like a nail?. That is one we will touch on later in the series. The General Theory of Relativity was, and still remains, a little unsettling because it throws certainty and absolutes out the window. You only know what fast is, because you know what is slow. You can only identify white because it exists in opposition to black. Up only exists because it is the opposite of down. I don?t move at 100 km/h, but only at 100 km/h relative to the ground. And so we can go on and on and on?

Some might think the above is a very elaborate way of starting a discussion on PE (Price Earnings) ratios. However, in my experience you have to explain things in unconventional ways if you want people to rid themselves of conventional wisdom. Dividing the price of a company by its net income gives you the company?s PE ratio. The problem is that the PE ratio is widely touted as a good indicator of value. Although it is a very well defined term, it is used very loosely. It is mostly used as a short-cut indicator of value. Get the message! There are no shortcuts in business/investment.

A PE ratio is the current price divided by the historical annual earnings of the company. If the price is $10 and the company earned $1 last year, then the PE is 10 ($10/$1). If the company earned $2 the PE is 5 ($10/$2).

Sometimes analysts talk about a prospective PE ratio. If the company earned $1 last year but someone thinks it will earn $2 next year, then the PE or historical PE is 10 and the prospective PE is 5. However, while analysts frequently talk about the prospective PE they don?t tell you that. THE QUALITY OF A PE RATIO AS AN INDICATOR OF VALUE IS RELATIVE TO WHETHER YOU ARE WORKING WITH HISTORICAL OR PROSPECTIVE EARNINGS.

A PE ratio uses net income, which is the same as after-tax earnings. Frequently, pre-tax earnings will be used. A UK company usually pays 30% tax. If the company?s price is ?100 and it earns ?7 of net income, its PE is 14. However, you can get someone using the pre-tax figure of ?10 (?10 less 30% = ?7) that tells you the company has a PE of 10. However, he/she won?t tell you that they are using a pre-tax figure. There is a 40% difference in the two PE ratios of the same company. THE QUALITY OF A PE RATIO AS AN INDICATOR OF VALUE IS THEREFORE RELATIVE TO

WHETHER YOU ARE WORKING WITH AFTER-TAX OR PRE-TAX EARNINGS.

On the other hand, the pre- and post-tax figures are important, depending on your benchmark. If your goal is to earn a better return than you would in a savings account you should use the pre-tax figure. The reason being that you have to pay tax on the interest earned on your deposit and thus it is rational to use the pre-tax earnings. You have to compare peaches with peaches (to paraphrase an old saying). THE QUALITY OF A PE RATIO AS AN INDICATOR OF VALUE IS RELATIVE TO WHETHER YOUR BENCHMARK IS A PRE-TAX OR AFTER-TAX BENCHMARK.

Assuming a price of $10 and historical earnings of $1, it is important to understand that you are paying for 10 years of future earnings today. However, that is only true if the future holds zero earnings growth. Both company A and B have PE?s of 10 and historical earnings of $1. B?s earnings are likely to grow at 10% per annum, while A?s are stagnant. This means that, all other things being equal, B is the cheaper company. THE QUALITY OF A PE RATIO AS AN INDICATOR OF VALUE IS RELATIVE TO THE GROWTH RATE OF FUTURE EARNINGS.

Some industries are very cyclical, while others can have a bad year that was truly extraordinary (beware: ?extraordinary items? is an accounting term that is widely abused). Take an insurance company which did business with a tenant of the World Trade Centre last year. While historical annual earnings may have been in the region of $1, $1.10 or $1.21 per share, it might have been only $0.50 last year. Assuming a price of $10, the current PE is 20 - which looks expensive. However, if you accept that 9/11 was a truly extraordinary event, then you can argue that normalised earnings should be at least $1.21, which will give you a PE of 8. THE QUALITY OF A PE RATIO AS AN INDICATOR OF VALUE IS RELATIVE TO HOW INDICATIVE LAST YEAR?S EARNINGS ARE OF NEXT YEAR?S EARNINGS.

PE ratios are very bad indicators of value for some industries simply because some industries are not very good at earning anything. Yet, the

companies do create value. Insurance companies are good examples. Just as many private companies prefer not to earn anything in order to minimize taxes, so many insurance companies will rather build value on the balance sheet than via the income statement. When valuing insurance companies, rather look at price as a multiple of book (i.e. asset) value than PE ratios. I never consider PE rations when valuing insurance companies. THE QUALITY OF A PE RATIO AS AN INDICATOR OF VALUE IS RELATIVE TO THE TYPE OF INDUSTRY.

Of course, people always want to know what an expensive PE is. Surely by now you have figured out that IT IS RELATIVE. Personally, I hardly ever work with a PE ratio directly. I prefer to use the inverse or E/P ratio, better known as the EARNINGS YIELD. If a company?s price is $10 and it earned $1, its PE is 10 and its earnings yield is 10% ($1/$10). I usually look for an initial after-tax earnings yield of 15%. However, if there is a strong possibility of future earnings growth I will take 10%. This translates to PE ?s of 6.6 ($10/$1.5) and 10 ($10/$1).

Whatever you are up to, I hope it is profitable and ethical!

Mr. B

mail_mrb@yahoo.com

Posted: 2002/12/02 08:43 View Archive