P/Es are misleading, though simplicity makes the P/E ratio one of the most commonly used valuation metrics. Read on to see the problems with P/E and how we apply a better measure of value. #WednesdayWisdom 1/15
The flaws with P/E ratio begin with the denominator – earnings. Accounting earnings are unreliable for two reasons: 2/15
1. Accounting rules changes - shifts in rules change reported earnings when there’s no change in the business.
2. Accounting rules manipulations – loopholes in the rules make it easy for executives to mislead.

3/15
Empirical research shows accounting earnings have almost no impact on long-term valuations. Additionally, P/E ratios ignore assets and liabilities that have a material impact on valuation. 4/15
If accounting earnings actually drove valuations, then companies with high EPS growth should command higher multiples. Conversely, companies with low or negative EPS growth should have lower PE multiples. As the image below shows, there is no such correlation. 5/15
The R2 value of 0.3% in the image above means that EPS growth over the past five years is statistically insignificant in explaining the difference in P/E ratios between stocks in the S&P 500. 6/15
Instead of P/E, ROIC is the primary driver of differences in stock valuations. The image below shows that ROIC explains 53% of the differences in the Enterprise Value/Invested Capital ratio (a cleaner version of the price-to-book ratio) for S&P 500 stocks. 7/15
The R2 value of 53% in the image above means ROIC explains over half of the difference in valuations between stocks in the S&P 500. This correlation means companies that improve their ROIC are more likely to see their stock prices rise. 8/15
It’s understandable why investors might think that accounting earnings drive stock prices. After all, you tend to see stock prices go down when companies miss earnings expectations and go up when they beat expectations 9/15
Headline numbers can have an immediate and dramatic influence on stock prices. The key word in that sentence is “immediate”. A big increase in EPS might drive short-term gains in stock prices, but it doesn’t create long-term value. 10/15
Investors need to be looking at ROIC rather than EPS, and they need to recognize that a P/E multiple tells you next to nothing about the actual value of a stock. 11/15
Our models and calculations, including our ROIC calculation, are 100% transparent because we want clients to know how much diligence we do to give them the best earnings quality and valuation models in the business. Learn all about our models here: newconstructs.com/education/mode… 12/15
And our models and calculations are 100% the best in the business according to @J_Fin_Economics @EY_US @HarvardHBS @MITSloan newconstructs.com/proof-of-the-s…. 13/15
Get all the details on the problems with P/E ratios at the page below.
newconstructs.com/p-e-ratios-are… 14/15
Get all the details on flaws with other common metrics at the page below. newconstructs.com/education/basi… 15/15

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More from @NewConstructs

Feb 18
Freshpet’s ($FRPT) rapid revenue growth has no doubt gained investors’ attention. However, while Freshpet’s revenue has tripled since 2016, Core Earnings have fallen in three of the past four years.
Growth and market share gains will be more difficult going forward. Freshpet faces competition from much larger firms in the pet food industry, and the rise in popularity of the company’s products is certain to garner more attention from existing competition.
To maintain its growth, Freshpet must spend much more heavily on operating expenses than the established competition. Freshpet’s operating expenses as a percent of revenue, at 44% over the TTM, are much higher than its large competitors.
Read 8 tweets
Feb 17
Quarterly earnings season may be winding down, but the real earnings season – annual 10-K filing season – is ramping up. See thread.
Since 2005, we’ve reported how traditional earnings measures are unreliable due to accounting loopholes that allow companies to manage earnings.
Going into the 4Q21 calendar earnings season, Street Earnings were more overstated than any time since 2012. Image
Read 13 tweets
Jan 27
We believe Bill Ackman's Pershing Square is wrong to purchase shares of Netflix and we fear that other investors will follow suit and purchase this dangerously overvalued stock simply because they trust and admire Bill Ackman. See thread $NFLX
We expect muted growth, such that is guided for in 1Q22, is the new normal, because competition is taking meaningful market share from Netflix and making subscriber growth more expensive. - photo cred JustWatch Image
The streaming market is now home to at least 15 services with more than 10 million subscribers Image
Read 16 tweets

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