Great write up. You're right, P/E has many flaws and is quite simplistic in many ways. Ideally, an adjusted metric should be calculated for valuation purposes - like for instance Owner's Earnings.
I completely agree. Each business reality requires its own specific adjustments.
It’s precisely those adjustments (and the "complexity" they require) that make seemingly simple metrics so popular imho, but often at the expense of real relevance.
Absolutely. Realistically, for institutional investors that need to go through manyu companies in a limited amount of time, metrics like PE are very useful, although not very sound to use in all cases.
This was a great read. You're absolutely right about the flaws of using P/E.
It's even more dangerous when it used as a screening tool...
I like how you said P/E is a start rather than the end. An investor needs to peel back the layers to ensure what form of adjustment to make.
That said, an adjusted P/E is still good as a 4th/5th "check" (with the superior EV and Owner Earnings multiples ahead of it) to see whether a stock is cheap or expensive relative to earning power.
I wasn't clear in that last paragraph. I meant adjusted P/E is ranked 4th/5th in terms of preference with EV and Owner Earnings ahead of it.
As you have accurately pointed out, four valuation checks is repetitive. If a stock is expensive relative to owner earnings, an adjusted P/E wouldn't change that decision.
One thing I've been thinking more about is ROIC or ROIIC x reinvestment rate as a way to assess for growth. It then eliminates the need to revenue, margins, etc. It does depend though on the implicit assumption that what has happened in the near past will continue into the near future.
It was a pleasure to write it. Thank you for reading it and taking the time to share your feedback.
I think with any model you’re always dealing with a bias-variance tradeoff: the simpler the model, the more biased it tends to be, and vice versa.
If you take P/E and fix the P while only varying the E, the model is simple but highly biased. If instead you fix the E and work your way back up to the P, you get something more relevant but also much more complex.
For ROIIC × reinvestment rate, that’s really the heart of the issue.
I think you’re right that the ROIIC × reinvestment rate framework is probably one of the best tools we have for predicting short- to mid-term performance, but you pay for that with complexity. Not just in the raw calculations, but also in how you interpret the situation so you can set up the right calculations in the first place (e.g., a simple accounting change can completely change the picture.)
But given that cost, when you know what you’re doing, I think ROIIC × reinvestment rate is a fantastic metric and one I was clearly underestimating before (less so now, thanks to you).
Great write up. You're right, P/E has many flaws and is quite simplistic in many ways. Ideally, an adjusted metric should be calculated for valuation purposes - like for instance Owner's Earnings.
Thank you for your feedback!
I completely agree. Each business reality requires its own specific adjustments.
It’s precisely those adjustments (and the "complexity" they require) that make seemingly simple metrics so popular imho, but often at the expense of real relevance.
Absolutely. Realistically, for institutional investors that need to go through manyu companies in a limited amount of time, metrics like PE are very useful, although not very sound to use in all cases.
This was a great read. You're absolutely right about the flaws of using P/E.
It's even more dangerous when it used as a screening tool...
I like how you said P/E is a start rather than the end. An investor needs to peel back the layers to ensure what form of adjustment to make.
That said, an adjusted P/E is still good as a 4th/5th "check" (with the superior EV and Owner Earnings multiples ahead of it) to see whether a stock is cheap or expensive relative to earning power.
Thank you for the feedback.
“Peel back the layers” is a great analogy, I wish I’d thought of it.
That many valuation checks feels like a lot to me; it increases the odds of noise creeping in and biasing decisions (at least in my framework).
Do you have an example (even a purely theoretical one) where an adjusted P/E as a 4th or 5th check would actually make you change your decision?
You're welcome.
I wasn't clear in that last paragraph. I meant adjusted P/E is ranked 4th/5th in terms of preference with EV and Owner Earnings ahead of it.
As you have accurately pointed out, four valuation checks is repetitive. If a stock is expensive relative to owner earnings, an adjusted P/E wouldn't change that decision.
♡LIKE
What a great read, thanks for writing.
One thing I've been thinking more about is ROIC or ROIIC x reinvestment rate as a way to assess for growth. It then eliminates the need to revenue, margins, etc. It does depend though on the implicit assumption that what has happened in the near past will continue into the near future.
Do you have any thoughts on this?
It was a pleasure to write it. Thank you for reading it and taking the time to share your feedback.
I think with any model you’re always dealing with a bias-variance tradeoff: the simpler the model, the more biased it tends to be, and vice versa.
If you take P/E and fix the P while only varying the E, the model is simple but highly biased. If instead you fix the E and work your way back up to the P, you get something more relevant but also much more complex.
For ROIIC × reinvestment rate, that’s really the heart of the issue.
I think you’re right that the ROIIC × reinvestment rate framework is probably one of the best tools we have for predicting short- to mid-term performance, but you pay for that with complexity. Not just in the raw calculations, but also in how you interpret the situation so you can set up the right calculations in the first place (e.g., a simple accounting change can completely change the picture.)
But given that cost, when you know what you’re doing, I think ROIIC × reinvestment rate is a fantastic metric and one I was clearly underestimating before (less so now, thanks to you).
https://open.substack.com/pub/investingliteracyhub/p/how-to-measure-stock-returns-the?utm_campaign=post-expanded-share&utm_medium=web
New post is out 📌 A simple framework on how sales growth, margins, and P/E combine to drive stock returns over time.
Link below.
https://open.substack.com/pub/investingliteracyhub/p/how-to-measure-stock-returns-the?utm_campaign=post-expanded-share&utm_medium=web
New post is out 📌 A simple framework on how sales growth, margins, and P/E combine to drive stock returns over time.
Link below.