Einstein had said, "Make everything as simple as possible, but not simpler."

Most people find it hard to give up their quest to over-simplify things. When faced with a complicated problem which we can’t grasp, we resort to over simplification and fool ourselves that we can deal with the problem. Charlie Munger had once said that if you don’t know the periphery of your circle of competence, your competence is questionable. But all our life we are in search for a Magic Formula for everything. If you type ‘magic formula’ on google search bar, it reveals 1.1 million results which includes magic formula for everything.

In investing, Greenblatt’s ‘Magic Formula’ suggests purchasing 30 ‘good companies’ – cheap stocks with a high earnings yield and a high return on capital. In his book ‘The Little Book that Beats the Market’ he claims that this beats S&P 500 96% of the time, and has averaged a 17-year annual return of 30.8%. For the lay investor, it offers market-beating returns without the complexity associated with a discounted cash flow analysis.

This isn’t too complicated to follow? Why, then, aren’t there millions of investors seeing Warren Buffett eye to eye in terms of returns?
The answer can be traced to simple mathematics. Let me start with an often used ratio P/E which is a ratio of share price to earnings per share (EPS). It can also be interpreted as the ratio of market capitalization to the net profit of the company.
Suppose I give you one of the following pieces of information about a company:

a) P/E ratio
b) Stock Price and EPS
c) Market Capitalization and Net profit
Do you get same amount of information from each one of these or different?

If you see carefully, you would note that the ratio, while being simpler, entails loss of information.

Take this information based on option a. Educomp Solutions, an education solution provider company in India, is selling at a P/E of 64, on the basis of FY07-08 earnings. The company has shown steady growth in profits and on trailing 12 month (ttm) EPS the P/E stands at 39. Another company, Mahindra & Mahindra quotes at a P/E of 8.59 on the basis of FY07-08 EPS. But the company’s profits are expected to be lower this year.

Take this information based on option a. Educomp Solutions, an education solution provider company in India, is selling at a P/E of 58, on the basis of FY07-08 diluted earnings per share. The company has shown steady growth in profits and on trailing 12 month EPS the P/E stands at 39. Another company, Mahindra & Mahindra is trading at 5 times the FY07-08 EPS. But the company’s profits are expected to be lower this year.

On the basis of this information, Educomp looks expensive but do you know exactly how expensive. Now let me provide you the information based on option c. Educomp Solutions reported a profit of Rs. 67.74 Crs. in FY07-08 and its current market capitalization is 4187 Crs. M&M reported a profit of Rs 1571 Crs and its current market capitalization is 8623 Crs.

Now you can see how gross the difference is.
The next big problem is the fact that profits are not guaranteed for any business. Nor are they expected to change in a predictable fashion. That’s why Graham insisted on taking average profits for a number of years instead of last year’s profit. M&M’s 3 years average consolidated net profit is 1490 Crs whereas Educomp Solutions’s average is 37.5 crs.

Now you can see that M&M’s market capitalization is only twice that of Educomp when M&M is a company 40 times as big as Educomp. Comparing P/E ratios doesn’t make this fact as obvious.

The absolute numbers give vital information. The defense expenditure of United States as a percentage of its GDP may not look substantially different from India’s but the defense spending of United States is almost the same as the rest of the world combined. You can tolerate the price of Catch table salt even though it’s 10 times the price of Tata salt on per kg basis, but you can’t tolerate a mere 15 percent increase in body temperature. The absolute numbers matter.

Many people fail to maintain well-oiled number crunching machines inside their skulls. They open calculators to convert dollars into rupees. For them the ratios are akin to precooked food that they lap up with ease without ever trying to find about the ingredients. If you can’t do simple number crunching, take my advice. Forget about investing in stocks. Buy index funds or keep your money in other safer assets like fixed deposits.

Coming back to P/E.

The P/E of a company can change due to many more reasons apart from changes in the performance of business. For example, the following table depicts a scenario where a company comes out with a 1:2 rights issue at the market price.

 Before rights issue After rights issue Paid up equity (Crs) 200 300 Face value 10 10 Shares outstanding (Crs) = equity/face value 20 30 Reserves (Crs) 800 1450 Networth = equity + reserves 1000 1750 Share price 75 75 Market capitalization (Crs) 1500 2250 Net Profit (Crs) 100 100 P/E 15 22.5

The cash infusion raises both the market capitalization and the number of shares of the company. However the newly added cash can’t change last year’s profit(!) which causes the P/E to shoot up from 15 to 22.5. However the newly added cash can’t change last year’s profit(!) which cause the P/E to shoot up from 15 to 22.5. Is the company more expensive merely because it has added 750Crs to the cash and its value has also increased by 750 Crs?

PEG ratio, which stands for (P/E)/Growth, takes this stupidity to a new level. This ratio does an excellent job in rationalizing any arbitrary valuation. The company is selling at P/E of 60 and its net profit has grown at 60%, the PEG is 1. So its not even defined correctly. It’s actually a ratio of P/E in decimal to growth in percentage terms.

That brings me to net profit growth, the holy grail of the markets. The growth figure doesn’t depend only on how high your current profit is. It also depends on how low your base was. The headlines scream: ‘Profit jump by 900%’ and you would see that the profit has come back from a lowly 1Crs to 10Crs. The analysts weren’t happy with that. So they invented Q on Q growth. That is the growth of profit in this quarter compared to last quarter. Most businesses have seasonal variations in the profits. There are many factors - sales in festive seasons are higher, financial year end impacts corporate spending. Even for non seasonal businesses, like IT companies, there is significant change in the business in different quarters because typically the IT budgets in the clients organizations are allocated in the beginning of financial year. Such is a fascination of the markets with Q on Q growth that the companies resort to profit smoothing. In a quarter of high growth, they will not report a major contract, in the next quarter if they fall short of guidance, they will show such earnings or even earnings recognized in advance(and then show them as receivables). The revenue recognition norms are twisted to make the curves smooth.

Does this mean we should not lay too much stress on the financials of the company? No. The analysis of the financials can give important clues to the characteristics of the business and the perception of the investors about the risks inherent in the business. However, such analysis (a) should be free from computational errors of the kind described above (b) should not be used to derive incorrect conclusion (c) should not be used to derive any conclusion at all.

Suppose I find a company which is making 30% return on networth and selling at less than book value and at 3 times the profit. I won’t jump to buy. I would usually gather information about the company to find out the reason for such high profitability. It may be due to temporary spike in output prices(like in commodity companies), due to one time factors or due to competitive advantage of the business. If the business is attractive, I would try to find why the stock is being undervalued so much. Markets are correct most of the time about most things. There are only few pockets in stock ticker space-time where they get it wrong and horribly wrong. You can not beat the markets without being wiser than the collective wisdom of the investors. It is easier said than done.

The numbers are byproduct of the business activity. Until you understand the business, your decisions based on the financial information are a shot in the dark. It is easy to do number crunching to tell how different variables are positively correlated with high return in past decade or century but investing is all about finding what would lead to better returns in future. To do this, there is no magic formula.