Investing By Forgetting P/E Ratios

Joel Greenblatt is a legendary investor who earned 50% returns per year while running Gotham Capital between 1985 and 1994. He also authored a book called The Little Book That Beats the Markets, which has been read by thousands of investors across

the world.

One of his secrets to investing is that he focuses on free cash flow rather than P/E ratios: "We try to stick with companies that are gushing cash flow. We don’t really think of value as low price to book or low price to earnings. We are actually valuing businesses based on cash flows like a private equity investor would. We are valuing businesses based on cash flows."

Everyone has heard of P/E ratios. It’s a company’s stock price divided by its earnings per share.

It’s perhaps the most popular valuation metric on Wall Street.

In theory, a P/E ratio is supposed to tell an investor how expensive a stock is relative to its purchase price. However, the “E” in P/E ratio doesn’t always accurately represent how much money a company earns.

A company might trade at a P/E ratio of 10x. That sounds pretty solid. But after you account for the fact that it legally or illegally overstated its earnings by a couple billion dollars—like Netflix or WorldCom—its “real P/E ratio” might be closer to

20x.

That sounds pretty awful.

So don’t rely on P/E ratios. Focus on free cash flow instead. It’s simply more accurate for every business.