Recently, a friend asked me a seemingly simple question: Why do you only use profit and cash flow to assess the fair value of a stock? He argued that even a stock with a high price-to-earnings ratio, such as 150, could still be considered “cheap” if it has a lower price-to-sales ratio of 5 or a price-to-book ratio of 0.9. Well, after many years on the stock market, I have moved away from these rigid criteria and hardly ever consider whether a share has a PE, PB or PS ratio of 9 or 25.
The Quest for Fair Value: Beyond PS and PB Ratios
To begin, it’s crucial to recognize that the journey of valuing a stock is a nuanced one. There’s no single formula that can give me the “correct” valuation of a company. While traditional metrics like the PS ratio and PB ratio are widely used to determine a stock’s fair value they each have limitations that can lead to misguided investment decisions if not understood properly.
The PS ratio measures the price of a stock relative to its annual revenue. In theory, a lower PS ratio suggests that a company is undervalued relative to its sales. A higher PS ratio, on the other hand, might indicate overvaluation. The PB ratio, on the other hand, compares a stock’s market price to its book value—the net value of its assets on the balance sheet. Traditional value investing has long held that a PB ratio below 1 is a sign of a potentially undervalued stock, suggesting the company is worth more “on paper” than its current market price.
However, the challenge lies in the fact that both the PS and PB ratios are inherently limited. They don’t necessarily account for the qualitative aspects of a business or its future growth potential. They can also be misleading if taken at face value without understanding the broader context in which a company operates.
Why I Don’t Focus on Fair PS or PB Ratios: Digging Deeper
When I evaluate whether a stock is worth investing in, I don’t place much weight on the PS ratio or the PB ratio. Here’s why:
- Book Value Does Not Reflect True Value: While book value can provide a snapshot of a company’s assets and liabilities, it fails to capture many of the intangible qualities that often define a business’s true worth.
- PB Ratio’s Inherent Contradiction: A PB ratio below 1 might seem like an attractive bargain—after all, it suggests the company’s market value is less than its book value. But here’s the paradox: the book value is backward-looking, based on historical costs and accounting rules, while the stock price is forward-looking, reflecting the market’s future expectations. Attempting to draw meaningful conclusions from these mismatched metrics is akin to navigating using a mismatched map. It tells you where the company has been, not where it is going.
- The Pitfalls of Overemphasizing Sales: The PS ratio, which compares a company’s sales to its market price, also has its limitations. Sales figures can be a misleading indicator of value. A business can generate significant revenue but still be unprofitable or fail to create shareholder value. For example, simply achieving high sales volumes does not guarantee that a company is operating efficiently or that it is managing its costs well. A firm might be aggressively discounting its products or spending heavily on customer acquisition without a clear path to profitability. In such cases, a low P/S ratio might attract investors who overlook the underlying weaknesses.
The Power of Profits and Cash Flow: A Fundamental Approach
So, if metrics like PS and PB are not the cornerstones of my investment philosophy, what is? The answer is straightforward: profit and cash flow and their development over time. Here’s why I focus on these two indicators:
- Cash Flow Reflects Real Financial Health: Cash flow is the lifeblood of any business. It represents the actual money that flows in and out of a company, which can be used to pay bills, invest in growth opportunities, or return value to shareholders. Unlike accounting profits, which can be manipulated through various accounting practices, cash flow provides a clearer picture of a company’s operational effectiveness. Positive cash flow means that a company is generating enough money to cover its expenses and reinvest in its future. It’s the financial equivalent of oxygen—you can survive without it for a while, but not indefinitely.
- Profitability Drives Long-Term Value Creation: Profits indicate a company’s ability to create value for its shareholders over the long term. A company that consistently generates profits demonstrates that it has a sustainable business model. It also indicates a competitive advantage, and growth potential. Profitability is also a key determinant of a company’s ability to reinvest in its operations, pay dividends, or buy back shares. All these things are crucial for driving shareholder returns.
- Flexibility and Strategic Options: Companies with strong cash flows and profits have the flexibility to make strategic decisions, whether that means pursuing acquisitions, investing in research and development, or withstanding economic downturns. They can choose to reinvest in growth, return capital to shareholders, or simply build up a cash reserve for future opportunities. This strategic optionality is invaluable in a rapidly changing business environment.
Bringing food to the table
Overall, my approach is straightforward. I look at those figures that are most closely related to my reason for investing in stocks. I invest in stocks because I want to become an owner of companies. I bear the risk and benefit from the success—like a real entrepreneur. So, I have to think like an entrepreneur.
In my view, a perfect entrepreneur must have only one goal: To create value in the long term. However, this value does not lie in selling as many products as possible. Just give me 1 million EUR/USD, and I’ll make 500,000 EUR/USD in sales. I promise. Hence, relying on a price-to-sales ratio to justify an investment is extremely foolish.
Likewise, increasing the book value does nothing for me. Does that increase my entrepreneurial freedom? My productivity? Does it help me to pay my staff? Does it put food on my table? I don’t think so.
The Role of Sales and Book Value in My Analysis
To be clear, I don’t completely disregard sales figures or book value. These metrics still play a role in my investment analysis, but they serve a different purpose:
- Sales as an Indicator of Growth and Market Position: While I don’t rely on the PS ratio to value a company, I do examine sales figures to assess growth and market position. Sales growth can be a sign that a company is expanding its market share, launching successful new products, or entering new markets. However, I’m particularly interested in understanding whether this growth is profitable. Is the company benefiting from economies of scale, or are its costs rising faster than its revenues? What do the trends in sales growth tell me about the company’s future prospects?
- Book Value in Context: Similarly, book value can provide context, especially when looking at capital-intensive industries like manufacturing or banking, where tangible assets play a significant role. A low PB ratio might indicate undervaluation in such sectors, but it is just one piece of a much larger puzzle. I use it as a supplementary metric, not the main criterion for making investment decisions.
Exceptions to Every Rule: The Case of Palantir
So while cash flow and earnings are my key metrics, every investor should acknowledge that there are always exceptions. For example, I invested in Palantir, a company that was quite far from being profitable (back then!). However, my decision was not based on a low PS ratio or any other traditional valuation metric. Instead, I was drawn to Palantir’s unique strategy, its potential for long-term growth, the vision of its management and the CEO Alex Karp, and its ability to disrupt multiple industries through data analytics.
I fully understood that investing in Palantir was a high-risk, high-reward bet, but it was a conscious decision based on factors other than its current profitability or traditional metrics. It’s a reminder that investing is as much art as science, and sometimes you need to take calculated risks to achieve outsized returns.
Cash Flow Versus Profits: Insights from Amazon
Some may argue that my focus on profitability would have led me to miss out on transformative companies like Amazon, which historically had a high PE ratio and minimal reported profits. But this argument misses a crucial point: Amazon always had strong cash flow. Jeff Bezos, Amazon’s founder, consistently prioritized cash flow over accounting profits.
In his first letter to shareholders in 1997, Bezos stated:
“When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.”
This strategy enabled Amazon to invest heavily in growth initiatives, new technologies, and global expansion, all while maintaining the financial flexibility provided by robust cash flows. Despite low profits on paper, Amazon was always in a position of strength. It generated strong cash flow, which allowed it to weather market volatility and continue investing in its future.
So looking at the price to cash flow ratio it is then?
As I mentioned at the outset, I’ve largely moved away from focusing strictly on earnings or cash flow ratios. In my experience, they’re not always meaningful indicators of a stock’s true potential. Instead, I prioritize examining how a company’s current valuation aligns with its actual and potential growth.
This approach allows for a more fluid and flexible evaluation, rather than adhering to rigid rules. For instance, a high price-to-cash-flow ratio might appear unattractive at first glance, but if the company demonstrates strong growth potential and a unique market position, it could still offer considerable upside. Similarly, rather than letting traditional metrics dictate my decisions, I consider the broader context: Is the company positioned for sustainable growth? Is it capitalizing on strategic opportunities?
I understand that this approach may offer fewer clear guidelines to follow, but that’s okay—every investment style is unique. What works for one investor may not work for another, and I’ve found that adapting my approach to the specific circumstances of each company ultimately leads to better decisions and long-term results.
Keeping It Simple: My Core Investment Philosophy
My approach is to keep things simple in a world filled with complex financial models, algorithms, and rapid information flow. I don’t try to outsmart the market or mimic other investors. Instead, I focus on the fundamentals: Why am I investing? What are my goals? Which criteria are decisive?
By sticking to these core questions, I avoid distractions by market noise or the latest trends. I focus on what matters most: profit and cash flow, the two key drivers of a company’s ability to grow, adapt, and create value over time. This strategy may seem simple, but it is not simplistic. It requires discipline, patience, and a willingness to look beyond the surface-level metrics that many investors rely on.
The Importance of Context and Nuance
At the end of the day, investing is about understanding context and nuance. Metrics like the PS and PB ratios might provide valuable insights. However, they are not the be-all and end-all of stock valuation. They should be used in conjunction with other indicators to paint a complete picture of a company’s financial health and growth prospects.
My philosophy emphasizes simplicity in a world of complexity, focusing on what truly matters. This is a company’s ability to generate profits and cash flow, which ultimately determines its long-term success and ability to “put food on the table.”
A Balanced Approach to Investing
Prioritizing profit and cash flow over other metrics when valuing stocks is about keeping things simple. My approach is rooted in common sense. I invest in companies that have a proven ability to generate profits and maintain healthy cash flows. Profits or cash flow are the parameters by which I measure value. They give a company room to maneuver. In short, they put food on the table. This circumstance applies to a company like Amazon, but also to the woodworker or shoemaker around the corner. In doing so, I aim to build a portfolio that aligns with my long-term goals and values, providing both financial security and growth potential. But as always, investing is a journey, not a destination.
All the best,
