Grasping straws – the PER


If leverage doesn't carry a risk premium and reported earnings were both a consistent proxy for free cash flow as well as reflecting all the liabilities (both on and off balance sheet), then a post interest earnings multiple might provide some sort of basis for a valuation. That of course would also be assuming a static market cost of capital and prospective growth rate. As per the Spartan response to Philip of Macedon's threat however, those represent some very big "IF's".

Notwithstanding the flaws, the Price earnings Ratio (PER) has been adopted as a quasi valuation currency, albeit more as a marketing tool by companies to lower capital costs and enhance executive remuneration, or by various share pushers. Unfortunately for the proponents of this metric, there has also been the inconvenience of changing accounting treatments that have distorted comparisons across both time and accounting standards zones. As a consequence and with statutory earnings increasingly diverging from the underlying reality of company trading, we have seen various incarnations of what were described in the 1980''s as EBBS (Earnings Before the Bad Stuff).

Perhaps ironically, the very attempts by regulators to tighten up accounting standards have in fact spawned a wild west of unofficial alternative measures that now form the basis of most markets 'adjusted' version of a true and fair view, albeit with limited consistency of application. So by all means, enjoy the various earnings definitions and PER's, but don't expect them to offer much in the way of insight into whether a stock is under or over valued, because it won't, regardless of what some salesman is claiming. Having read the preceding sections on this site, hopefully you may have already arrived at this conclusion.

Market PER (adj & statutory)

Normalised operating free cash flow might be what an investor needs, but what you get from companies and industry are post interest earnings. As the statutory version of these get burdened with increasingly arbitrary P&L recognitions by regulators, these official versions of events have become increasingly divorced from the reality of a business's underlying trading performance. Ironically, this has exacerbated an already growing trend by investors and companies to revert to various versions of 'adjusted' earnings. Unfortunately, companies compete for capital and can often stretch the envelope on what even 40 years ago were disparagingly referred to a EBBS (earnings before the bad stuff).  

So which one to use? Ideally, neither, but be aware that there is an entire industry with financial incentives to encourage you to the rose-tinted version, notwithstanding these may have limited connection with the longer terrm cash flow generative characteristics of the company and Caveat Emptor

Market PER (adj) & + 1 Year

As a discounting mechanism, it seems more sensible to use a forward expectation of events if one is going to try an anticipate a valuation That of course presupposes a manageable forecasting margin of error.

Back in 2008 however, markets were forced to slice over 60% from their original 2009 market earnings expectations and 2020 seems to be heading for a re-run of this!

Org Rev & EPS Growth (adj) 

Statutory earnings usually get hammered by impairment writedowns in each downswing, while excluding these and 'exceptional' charges can partially insulate the effects in the 'adjusted' version. Underlying all of this however, is the  reality of the impact of swings in marginal organic revenues. 

FCF Conversion

If an asset can be defined by the NPV of its future anticipated free cash flow, then wouldn't it be helpful to know if it is generating any?

Sometimes I wonder if those pushing an EPS and PER valuation understand that the price of funding growth is that a portion of the cash flow has often to be reinvested, or just hope that their 'investors' don't.

Market Op FCF Yield

Apply a more realistic free cash flow conversion from adjusted net income and strip out the capital structure distortions (and NPV of all those juicy hidden on/off balance assets and liabilities) and you may get a little closer to discovering what the real operating free cash flow yield might be for the market. 

While this may provide you with an absolute measure of return, it is up to the aggregate of investors as expressed by markets to determine whether this offers enough of a relative return to compensate for the relative risk and growth prospects.