Tuesday, 20 March 2012 - 20:00

 

Charts

Earnings and PE

9 March marked the 3rd anniversary of the bottom of the 2007/2008 bear market, where the S&P500 index declined a massive 57% to 9 March 2009 from its October 2007 high. Then in just 2 years, the same index gained 100% from the lows made! Most global stock markets followed a similar pattern.

In trying to understand valuations, let’s revisit some basics. The value of a business is the discounted value of its future earnings at an appropriate discount rate. This should be relative easy to arrive at, but we know that because we are dealing with future uncertainty, there is a range of possible outcomes, hence the ongoing price volatility.

At the core, there are only 2 variables that affect the value of a share of a business – the income that it will generate, and the discount rate applied to that future income stream in order to arrive at a net present value. Expanding on each of these:

• A 100% shareholder has a claim on all of the future earnings generated by that business. Therefore a part shareholder has a proportional share in those future earnings. Some of the earnings will be received by way of a dividend, while typically the bulk will be reinvested back into the business for future growth and hence higher future dividends.

• The discount rate applied to the future stream of income is the second main factor in valuing a company. While the discount rate is affected by the prevailing interest rates, a rational investor will want to apply a higher discount rate to a more cyclical business, while one with superior management, a strong balance sheet and better quality and higher earnings growth, will justify a lower discount rate.

Instead of quoting discount rates, use is made of the price to earnings (PE) ratio, which is more or less the inverse of the discount rate. i.e. a company with steady and growing earnings, a strong balance sheet and quality management will justify a higher PE ratio. This metric is widely used and typically easier to understand.

The effect of the multiplication of these two factors can and does cause the price volatility that we see on a daily, weekly, and monthly basis. For example look at the reported earnings per share for all the S&P500 companies. It peaked in mid-2007 at around $85. Analysts would have been forecasting various forward levels around this, but then came the global financial crisis and earnings fell dramatically to below $10 a share by mid-2009.

As reduced earnings were quickly factored into investor forecasts throughout 2008, so share prices tumbled, eventually ending down almost 60% off the peak. But the interesting thing is that just as quickly as company earnings fell, so they have reversed all the way back up again with the 12 months to the fourth quarter of 2011, with almost all companies having reported, reflecting earnings per share of $87. Forecasts from S&P expect these to rise to $100 for the full 2012.

The chart below reflects S&P500 earnings from 1970 with the massive 2008 dip and subsequent recovery.

Source: Crestmont Research

In addition to the sometimes very volatile earnings, the multiple that investors apply to those earnings has a huge impact on valuations over various periods. I.e. an investor might suffer a loss from a company, which delivers on its expected earnings, because the rating on these earnings goes down. For example earnings may move up as expected from say 23 to 35, but the rating drops from an initial 18 to 10, resulting in a price decline from 414 to 350.

The only certainty with any investment is the price paid. Other than this, an investor does not know the exact details of the future earnings stream or the future price that an investor will be willing to pay for those earnings, making forecasts difficult.

A prudent investor will look at both the level of earnings and the rating of these earnings when making an investment.

Kind regards,

Ian de Lange
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

Tue, 20 Mar 2012

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