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Why profits aren’t all made equal and what that means for PE ratios

PE ratios are the most common way of valuing companies, but differences in earnings quality mean they have their limits.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

A Price to Earnings (or PE) ratio is the most common way of assessing a share’s valuation. It’s calculated by dividing earnings per share (“earnings” by the way is just another word for profits) by the share price.

The resulting number tells you how much investors are paying for a single pound’s worth of earnings. A PE ratio of 20 means that investors are prepared to pay £20 for every £1 of profits the company generates.

All things being equal a company with a lower PE ratio is “cheaper” than a company with a high PE ratio.

However, where profits are concerned all things are not equal.

Just as a cheap frozen lasagne might seem good value until you look at what’s actually in it, profits vary in quality too. We think cash flow yields can be a useful, and relatively simple, way for investors to cut through any horseplay with profits, and assess the quality of earnings.

Cash vs profits – and why it’s important

When we talk about profit quality we’re talking about a couple of things.

Reliability is one factor. Profits that turn up year-after-year are clearly better than those that are unpredictable. Unfortunately there’s no quick fix on assessing the reliability of a company’s earnings – you have to make a judgement about the business model and look back through past annual reports. Remember though, past performance isn’t a guide to future returns.

Profits that convert into cash are also generally considered to be higher quality. That’s a more complex idea to explain, but fortunately an easier criteria to assess.

The crucial thing to remember here is that not all profits are cash profits. And that’s because not all revenues are cash revenues.

Carillion is a good example.

Carillion had several major construction contracts and booked revenue on those contracts as it completed the work. However, the end customer wasn’t due to pay cash until the end of the contract, and, for a variety of reasons wasn’t willing to pay the expected sum on completion. The profits Carillion had booked on those revenues never turned up, and instead became losses.

The advantage of looking at cash, is that it’s real, tangible and here today. While revenues and profits can be recorded based on promises – cash is only counted when it’s in the bank.

Finding cash flows in a company statement

There are two particular measures of cash coming into a business that are useful when it comes to valuation: Operating Cash Flow and Free Cash Flow.

Operating cash flow can be pulled directly from a company’s annual report – the cash flow statement to be precise. It measures how much cash the company’s core business has brought in and excludes dividends, investment (a.k.a. capital expenditure) and borrowing.

Cash Conversion

Cash conversion can’t be used to directly value a company, but is analytically useful nonetheless.

As the name suggests it measures how much of a company’s profits are in the form of cash. It’s calculated by dividing operating cash flow by operating profit.

Generally speaking, the higher the level of cash conversion, the better.

However, no company can abandon capital expenditure altogether. Equipment needs replacing and buildings need upgrading, so operating cash flow can be a bit simplistic. Some businesses, like telecoms for example, carry out billions of pounds of capital expenditure every year and it’s vital to their continued existence.

Instead we can look at free cash flow. This is operating cash flow minus capital expenditure (represented by the “property, plant and equipment” line in a cash flow statement). It gives an idea of how much money a company has to pay dividends, pay down debt and acquisitions in any given year.

Cash flow yields

Just working out how much cash a company generates isn’t all that useful in itself – just as knowing how much profit a company makes isn’t all that useful. What’s important is how much you’re paying for that cash flow.

We think the best way to look at that is a free cash flow yield. It’s presented as a percentage and you can think of it a bit like a dividend yield – except that it isn’t paid out. It tells you how much cash your investment generates each year as a percentage of the business’s total value, and is calculated using the formula below.

Free Cash Flow Yield = (Operating cash flow – capital expenditure)/total business value (or market capitalisation)

Both operating cash flow and capital expenditure are included in companies’ annual reports. Market capitalisations are easily available on the internet, including on the share factsheets on the HL website.

Why does this matter for valuation?

Well, it matters because, just like anything else you buy, high quality companies tend to trade at higher prices. That is to say they trade on higher PE ratios.

However, more expensive companies can still be better value, if they are of sufficiently high quality. How can you tell if Company A is really cheaper than Company B if it might actually just be a worse business?

We think cash flow yields give investors a useful way to help solve this problem.

If two companies trade on the same PE ratio, but one has a higher free cash flow yield then we generally consider that business to be better value. You’re getting a higher quality business for the same price.

This article isn’t personal advice. If you’re not sure whether an investment is right for you, seek advice. All investments fall as well as rise in value, so you could get back less than you invest.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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