Hi Reader,

As a private investor, I've spent years exploring analysis metrics to find hidden gems.

But, there's one widely used investment metric that can be deceiving..

WHAT IS THIS METRIC?

Many investors use this ratio to get a quick idea of a stock's value.

And I'm willing to bet that you not only know this ratio, but use it regularly:

A low PE ratio can indicate a 'cheap' stock.

But, it's not as simple as it seems.

And, it's often misused by many investors..

WHAT ARE THESE INVESTORS DOING WRONG?

Let's see a real-life example.

In this article, the writer discusses the forward PE of Lloyds Bank.

They compare it to the average PE ratio of the FTSE 100 Index.

Can you spot the problem?

Comparing a single bank to a basket of 100 diverse companies doesn't provide an accurate picture.

The writer suggests comparing Lloyds to other major banks.

But, this doesn't solve the core problem..

WHAT'S THE BIG RISK WITH THIS METRIC?

Not only is using the PE ratio in isolation problematic, but it's also susceptible to manipulation.

Companies can engage in 'Earnings Management' practices, like:

Delaying expenses or recognising one-off gains.

This can artificially lower the PE ratio.

Potentially leading investors into overpaying for a stock that might not be as cheap as it seems.

WHAT CAN WE DO ABOUT IT?

For Index Fund Investors: The PE Ratio has a lessened impact because these funds hold a basket of stocks, averaging out potential misinterpretations.

For Private Investors: Look beyond the PE ratio.

• Past Performance: See how a stock's current PE compares to its average PE over the past 10 years. This helps identify long-term trends and gauge investor sentiment towards the company.
• FCF Analysis: Unlike reported earnings, Free Cash Flow represents the actual cash a company generates after accounting for expenses and reinvestments. FCF can provide us a more reliable picture of a stock's financial health compared to earnings. We can also compare FCF to its historical averages.
• Discounted Cash Flow: While DCF can be a useful tool, it relies heavily on assumptions. Be wary of overly optimistic projections. As the late Charlie Munger once said, "Warren often talks about these discounted cash flows, but I’ve never seen him do one."

See you next month,

Ozbourne Foreman

P.S. Want to see my first private equity investment? Check out my latest video, "Starting a Private Equity Portfolio at 24".

Disclaimer: I do not provide financial advice. Any views or opinions shared are for informational purposes only and should not be considered as professional advice. Always consult with a qualified financial advisor before making any investment decisions.