When targeting cheap value stocks, do bargain hunters use the price-to-earnings (P/E) ratio too much?
I see why people love using the P/E ratio to find cheap shares. Using one number to show the cost of a company relative to earnings is simple. I could probably teach it to a six year old. For those hunting cut-price stocks, this ratio seems like a good place to begin.
But it’s a very surface-level piece of information. A P/E ignores cash, debt, assets, and other important aspects of valuing a company. I don’t care how much a firm makes if it can’t afford its debt financing – the very issue that collapsed Cineworld last year.
Cheapest stocks
Other valuation metrics can make searching for cheap shares easier. The EV/EBITDA (enterprise value to earnings before interest, taxes, depreciation and amortisation) ratio is a similar valuation tool that takes debt and cash into account. A price-to-book (P/B) ratio likewise evaluates the price compared to the value of assets in the book value.
But when searching for the cheapest stocks on the market, I’d throw all these metrics in the bin – at least to begin with.
Instead, my strategy is inspired by Warren Buffett. At Berkshire Hathaway annual meetings, Buffett discusses his thought process for choosing stocks in some detail. I can flick YouTube on and listen to a billionaire investor reveal insights into how he mulls over a stock.
Strangest thing
The strangest thing is he rarely talks about the numbers side of things. He won’t bring up a stock and then opine about its valuation ratios. In fact, he rarely mentions any kind of number at all.
Now, I don’t doubt that he has an eye for financials. He also probably has a crack team of Ivy League graduates who scan balance sheets and income statements with a fine-tooth comb. But numbers, ratios, and other metrics are secondary to his thought process.
Instead, he focuses on more tangible aspects of a company. He talks about why its customers buy the products and why they might continue to – or why they might stop.
For example, Berkshire bought McDonald’s stock only to sell one year later. When quizzed on the reason for the sale, Buffett didn’t mention P/E or earnings or revenue.
He didn’t mention a single number. What he did talk about was Big Macs and Quarter Pounders.
While he thought McDonald’s was a great company, he noticed it didn’t have a massive competitive advantage.
Not lovin’ it?
Fast food enjoyers eat where is convenient, he noticed. They don’t tend to have a sense of loyalty to one fast food outlet or the other.
While this simple detail isn’t going to ruin McDonald’s stock, Buffett felt it wouldn’t deliver the 20% or more yearly returns that his company is known for achieving.
So when looking at my own portfolio, I’m reminded the value of a stock is more than numbers and ratios. Understanding the customer and their motivations plays a large role in finding high-quality, underpriced shares.
