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March 10, 2003 2:24 p.m. EST

SPECIAL REPORT: SHAREHOLDER SCOREBOARD

How to Avoid the P/E Trap

DATA
By ALFRED RAPPAPORT
Special to THE WALL STREET JOURNAL

Performance of 1,000 Major U.S. Companies Compared With Their Peers in 80 Industry Groups3 An Alphabetical Listing of 1,000 Major U.S. Companies, With Returns and Ratings4 The Best Performers5 (1, 3, 5, 10year) The Worst Performers6 (1, 3, 5, 10year) Top Guns7 The 100 Biggest Companies8 Dow 30 Companies9 How Industry Groups Fared10 Biggest Reversals of Fortune11 The Most-Improved Companies12 Honor Roll13 Laggard List14

Despite accounting scandals that raise questions about the quality of corporate earnings reports, and allegations that Wall Street research is tainted by conflicts of interest, investors continue to rely on the price/earnings ratio as the near-universal benchmark to evaluate stocks. What's wrong with this picture? Plenty. P/E-based recommendations barrage individual investors in Wall Street research reports and investment newsletters. A parade of money managers and analysts appearing on cable television say things like, "At next year's estimated earnings per share of $2.50 and a P/E of 15, our target price is $37.50 -- 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.

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. Contrary to those who believe stocks are priced according to a short-term outlook, most companies need 10 to 20 years of value-creating cash flows to justify their stock prices. 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.

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Misleading Picture

Relying on P/E numbers is a prescription for disappointing investment results because earnings snapshots have little to do with what determines a company's value. Earnings, which may include revenue for which a 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. At Home Depot Inc., for example, cash flow as a percentage of operating income averaged just 10% over the past five years, compared with 222% for General Motors Corp. That's because Home Depot's capital expenditures, primarily for new stores, exceeded depreciation, while at GM, with its long-established facilities, depreciation was greater than capital expenditures. Furthermore, the bottom line reflects a series of assumptions companies make about the future. For example, earnings may include assumptions about pension-plan returns, restructuring costs, uncollectable receivables and warranty expenses. Investors ignore risk if they look at earnings alone. Technology stocks with highly uncertain prospects are riskier and warrant higher discount rates than consumer staples, such as food stocks. Prospects beyond the 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 no current earnings or its aggressively managed earnings are suspect? Though most analysts acknowledge these shortcomings, they claim they can identify investment opportunities by comparing P/E multiples of companies within a single industry. According to this relative P/E approach, low P/E stocks within the group are ordinarily more attractive than high P/E stocks. But is Sears, Roebuck & Co. cheap just because it trades at a P/E of four, compared with Wal-Mart Stores Inc.'s 27? Is Wal-Mart stock necessarily unattractive because of its much higher multiple? Without evaluating cash-flow prospects and risk, there is no sound basis to conclude that either Sears or Wal-Mart is a buy, hold or sell. Another rule of thumb analysts often use is that stocks are attractive when their P/E multiples are less than the company's projected three-year to five-year earnings-per-share growth rate. This so-called PEG ratio is the P/E divided by the projected growth rate. The basic idea is that the lower the PEG, the less you are paying for a company's future earnings. 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. If forecasting distant cash flows seems too speculative to give up the P/E numbers as an investment tool, investors should at least identify the market expectations that a stock's P/E ratio implies. Determining the

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cash-flow growth rate needed to justify the company's P/E makes that possible. Knowing current expectations is essential because to earn superior returns, investors must correctly anticipate revisions to expectations.
Cash Flow/Earnings 10 0.25 0.50 0.75 1.00 1.25 Price/Earnings Multiples 20 30 40 50

17.7% 27.4% 33.2% 37.5% 40.8% 8.2 2.6 -1.4 -4.7 17.7 12.2 8.2 5.2 23.4 17.7 13.8 10.7 27.4 21.7 17.7 14.7 30.6 24.9 20.8 17.7

The table to the left presents implied annual cashflow growth rates for a range of P/Es and cash flow/earnings ratios. The table assumes an expected annual return of 10% -- a common benchmark for the stock market -- over a 10-year forecast period, and also assumes that after 10 years, cash flows grow at an estimated inflation rate of 2% annually. It's not surprising that cash-flow growth rates increase as P/Es increase. Also, the required cashflow growth rate declines as the cash flow/earnings ratio rises.

Here's how it works for a stock trading at 30 times earnings. Assuming that earnings will closely track cash flows over the next 10 years, the table tells us that the implied cash-flow growth rate is 13.8%. But earnings and cash flows can vary substantially, and an investor might make other assumptions after doing some research about the company. Suppose you expect cash flow to be only 50% of net operating income. The cash-flow growth rate required to justify a P/E of 30 then jumps to 23.4%. 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. A low P/E stock can actually require greater growth expectations than a high P/E stock. For example, as the table shows, a stock trading at a 20 P/E, with a 50% cash flow/earnings ratio, implies a cash-flow growth rate of 17.7%. In contrast, the stock with a much higher 30 P/E but with cash flow equal to earnings requires only 13.8%.
Company PriceCash Earnings Flow/Earnings 26 15 15 28 13 18 31 26 79% 92 10 63 43 77 122 70 CashFlow Growth 14% 5 36 19 13 10 11 16

Coca-Cola General Electric Home Depot IBM McDonald's Merck Microsoft Proctor & Gamble

The second table, showing price-implied cash-flow growth rates for eight stocks in the Dow Jones Industrial Average, helps to illustrate how this works. P/Es are as of the end of last year, and cash flow/earnings percentages for 1997-2001 were calculated by Michael J. Mauboussin and Kristen Bartholdson of Credit Suisse First Boston. Note that while Microsoft has the highest P/E multiple, its required growth rate is relatively low at 11% due to its extraordinarily high 122% cash flow/earnings ratio. Home Depot, by contrast, has a much lower multiple of 15 but a substantially higher 36% required growth rate because of its low 10% cash flow/earnings ratio.

Establishing the cash-flow growth rate implied by a stock's P/E multiple certainly is a step up from making simple P/E-driven investment decisions, but it's not enough. The implied-growth-rate-calculation depends in part on an assumed forecast period. The longer the assumed period, the lower the growth rate, and a shorter

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period implies a higher rate. An assumed forecast period of, say, 10 years is likely to be too long for some companies (such as personal-computer companies) and too short for others (like pharmaceuticals). To develop sound estimates for the forecast period and evaluate whether the implied cash-flow growth rate is reasonable, investors need to examine the competitive dynamics of the industry and the company's specific strategy. If conducting competitive strategy analysis still seems too speculative and time-consuming, get the "answer" from the market and free yourself from the burden of having to make independent forecasts. There are a number of sources -- Value Line Investment Survey, Standard & Poor's, Wall Street reports (available directly or via services like Multex.com1) and other research services -- to come up with a market consensus forecast for the key drivers of cash flow: sales growth, operating profit margins and investment expenditures. Once you determine the market's expectations for future cash flows and the cost of capital, it's possible to calculate the market-implied forecast period -- that is, the number of years of cash flow needed to justify the stock price. (A step-by-step tutorial and downloadable spreadsheets to do this analysis are available at www.expectationsinvesting.com2.) Armed with the expectations embedded in the current stock price, you can evaluate the likelihood of meaningful increases or decreases in market expectations. In the final analysis, the decision to buy or sell a stock will depend on whether prospective changes in expectations are large enough to provide a comfortable margin of safety. 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. Let's return to Wal-Mart and Sears, simply to illustrate how the process works. It would take nine years of expected sales growth at 12.5% to justify Wal-Mart's recent price of $48. Suppose that after some analysis you believe there's a 25% chance that Wal-Mart's aggressive additions of superstores, expanded merchandise offerings and failed competitors could produce 13.5% annual sales growth, a 25% probability that intensified competition will lower growth to 11%, and a 50% chance that current market expectations will persist. How sensitive is Wal-Mart's stock price to the changes in expectations? For the upside scenario, the stock would rise 21% to $58, and the downside scenario would push the stock down 17% to $40. Because the upside gain is offset by an equally probable loss, the stock looks reasonably priced.
Not So Cheap?

The Sears story is different. Just a single year's growth at a consensus rate of 3% rationalizes the stock price. However, any meaningful change in expected sales growth that also affects margins would have a big impact on value. Suppose, for example, a forecast of 3.5% sales growth on the upside and 2% on the downside. Sears stock would increase by 27% to $28 and decrease by 59% to $9, respectively, from its recent level of about $22 if the market revised its expectations. An investor making these assumptions would likely be a seller rather than a buyer of the stock. These should not be construed as investment recommendations. The lesson is that simple P/E rules for investing can lead to unintended and costly mistakes. For an investor whose expectations were close to the illustration presented here, Sears would not be "cheap" because of its low P/E multiple, and Wal-Mart not

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necessarily overvalued despite its high multiple. 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. If analysts began to publish the forecasts supporting their recommendations, P/Es would become irrelevant and the obsession with "E" would quickly evaporate. The Financial Accounting Standards Board can help by prescribing that corporate income statements clearly detail how much of the bottom line comes from cash flow and how much from noncash accruals that depend on management assumptions about uncertain future outcomes. Companies then would be more likely to follow Coca-Cola Co.'s recent decision to stop providing quarterly and annual earnings guidance so that analysts and investors focus instead on the company's long-term prospects. This stacks the odds in favor of better corporate management and investor performance and offers the single best remedy for restoring confidence in capital markets. -- Alfred Rappaport, Leonard Spacek professor emeritus at J.L. Kellogg Graduate School of Management, Northwestern University, Evanston, Ill., conceived the Shareholder Scoreboard. He is shareholder-value advisor to L.E.K. Consulting LLC, an international growth-strategy consulting firm that performed the calculations for this special section. Dr. Rappaport is co-author with Michael J. Mauboussin of "Expectations Investing: Reading Stock Prices for Better Returns"; the paperback edition was published by Harvard Business School Press in February 2003. He lives in La Jolla, Calif.
URL for this article: http://online.wsj.com/article/0,,SB104698852655744100,00.html Hyperlinks in this Article: (1) http://www.Multex.com (2) http://www.expectationsinvesting.com (3) http://online.wsj.com/public/resources/documents/scoreboard2003-peers.html (4) http://online.wsj.com/public/resources/documents/scoreboard2003-alpha.html (5) http://online.wsj.com/public/resources/documents/scoreboard2003bestperformers.html (6) http://online.wsj.com/public/resources/documents/scoreboard2003worstperformers.html (7) http://online.wsj.com/public/resources/documents/scoreboard2003-topguns.html (8) http://online.wsj.com/public/resources/documents/scoreboard2003100biggest.html (9) http://online.wsj.com/public/resources/documents/scoreboard2003-dow30.html (10) http://online.wsj.com/public/resources/documents/scoreboard2003industrygroup.html (11) http://online.wsj.com/public/resources/documents/scoreboard2003bigreversal.html (12) http://online.wsj.com/public/resources/documents/scoreboard2003mostimproved.html (13) http://online.wsj.com/public/resources/documents/scoreboard2003honorroll.html (14) http://online.wsj.com/public/resources/documents/scoreboard2003laggard.html