The Price-to-Earnings (P/E) Ratio is great...when it works.
Here are 3 times when it DOESN'T work🧵⤵️
Here are 3 times when it DOESN'T work🧵⤵️
1/ Accrual accounting
A Net Income Statement uses ACCRUAL accounting, not CASH accounting.
What's the difference? ⤵️
A Net Income Statement uses ACCRUAL accounting, not CASH accounting.
What's the difference? ⤵️
Think of it like this:
1⃣ You buy a car for $33,000
2⃣ You plan to own it for 10 years
3⃣ You plan to sell it for $3,000 after that
The left is what ACTUALLY happens
The right is what ACCRUAL accounting says happens
1⃣ You buy a car for $33,000
2⃣ You plan to own it for 10 years
3⃣ You plan to sell it for $3,000 after that
The left is what ACTUALLY happens
The right is what ACCRUAL accounting says happens
There are some companies where this makes a HUGE difference.
Take $NFLX for example. It spends hand-over-foot on content.
👉Because of depreciation and amortization, it spreads out all those costs over the "lifetime" of the content.
The result⤵️
Take $NFLX for example. It spends hand-over-foot on content.
👉Because of depreciation and amortization, it spreads out all those costs over the "lifetime" of the content.
The result⤵️
There's nothing wrong with accrual accounting...
As long as you realize it might not tell the entire picture
As long as you realize it might not tell the entire picture
2/ EQUITY INVESTMENTS INCLUDED
Because of a relatively-recent SEC decision, companies need to include non-realized gains and losses on their investments as part of income.
We can see the problem this causes by looking at $SHOP⤵️
Because of a relatively-recent SEC decision, companies need to include non-realized gains and losses on their investments as part of income.
We can see the problem this causes by looking at $SHOP⤵️
We all know the company ran in to troubles, but not THAT big.
What's going on here?
A few years back, it made an investment in $AFRM.
What's going on here?
A few years back, it made an investment in $AFRM.
As with all companies like Affirm, it's stock is down MASSIVELY over the past year.
This doesn't affect Shopify's underlying business AT ALL
And yet, it shows up on Shopify's income statement as a $1.2 BILLION loss!
This doesn't affect Shopify's underlying business AT ALL
And yet, it shows up on Shopify's income statement as a $1.2 BILLION loss!
Think about how silly this is...
⚫️If you earn $100,000
⚫️But you lost $300,000 in the stock market this year
⚫️You'd get to claim your "earnings" were ($200,000)
That would be your *E* in P/E
It doesn't make sense for you. It doesn't make sense for stocks
⚫️If you earn $100,000
⚫️But you lost $300,000 in the stock market this year
⚫️You'd get to claim your "earnings" were ($200,000)
That would be your *E* in P/E
It doesn't make sense for you. It doesn't make sense for stocks
3/ One-Time Events
Sometimes, a one-time, *non-repeating* event has an outsized affect on earnings.
Consider when $SBUX entered into an agreement with Nestle
Sometimes, a one-time, *non-repeating* event has an outsized affect on earnings.
Consider when $SBUX entered into an agreement with Nestle
Because of this partnership, Starbucks received a one-time, $1.4 BILLION payment.
That had to be counted in the company's earnings.
That had to be counted in the company's earnings.
What happens when EARNINGS go up?
The P/E ratio goes ⬇️, making a stock look much cheaper than it really is
The P/E ratio goes ⬇️, making a stock look much cheaper than it really is
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To review 3 times when the P/E ratio DOESN'T work:
1⃣ When ACCRUAL accounting creates massive differences between earnings and cash flow.
2⃣ When EQUITY INVESTMENTS cause huge swings in earnings
3⃣ When ONE-TIME, NON-REPEATING events cause earnings to surge
1⃣ When ACCRUAL accounting creates massive differences between earnings and cash flow.
2⃣ When EQUITY INVESTMENTS cause huge swings in earnings
3⃣ When ONE-TIME, NON-REPEATING events cause earnings to surge
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