One of the simplest analytical tools available to private and professional investors is the PE ratio. It is easy to calculate, easy to use – and easy to abuse! It can be the investor’s friend if used wisely, but this in turn implies a solid understanding of both its possibilities and pitfalls.
To understand the issues around the PE ratio we need to look at it in more detail. Firstly, it can be calculated by dividing the market price per share, by the bottom-line accounting earnings for that share. So if ’Investco’ is trading at R50 per share and its earnings per share are R5, the PE ratio will be R50/R5 = 10. Also, by dividing 100 by the PE ratio, we can calculate the percentage return that the share will earn us at its current price (The ’Earnings Yield’). In the case of Investco, this would deliver an earnings yield of 10%.
So in the first instance, by calculating the PE ratios of shares we are interested in, we can rank them on the basis of their PEs. The lower the PE the better, because looked at slightly differently, PEs tell us how much we must pay for every rand of earnings. In the case of Investco, a PE of 10 means that we are paying R10 for every R1 of earnings. But if Budgetco, a similar company in the same industry as Investco, is trading at a PE of 8, all other things being equal it would be a better investment at just R8 per R1 of earnings. Or, alternatively, it would deliver an earnings yield of 100/8 = 12,5%.
Potential pitfall #1
The astute reader might have noticed that the PE ratio depends on two different types of measures. One is a market-based measure (i.e share price), whereas the other is an accounting-based measure (earnings per share). And herein lies our first potential problem; research shows that in many instances there is no strong correlation between accounting earnings and market price.
There is, however, a strong relationship between free cash flow per share, and market price. Free cash flow (FCF) is the cash profit left over after the necessary replacement of fixed assets, and/or after any increases in working capital. Free cash flow can be used to pay off debt, pay dividends to shareholders, and/or invest in new assets to grow the business.
FCF is real, tangible surplus profit as opposed to accounting profits, which may be the result of manipulations by cleverly creative accountants. Where accounting profits are very similar to free cash flow, (and where the company produces stable annual earnings), then the PE ratio is a good indicator of the true value of a share. However, where annual accounting profits differ considerably from annual FCF, any value calculation must be treated with caution.
Ranking shares on the basis of their PEs might work well for companies that produce stable annual earnings and have stopped growing, but it gets a bit trickier when we factor growth into the equation. One of the first things that beginner investors learn is that high-growth companies have high PEs. What we mean specifically by high-growth is that these companies are growing their earnings (profits) quickly, so that next year’s earnings are expected to be higher than this year’s, and in the year after that, higher still.
Because we expect higher earnings in future, we are prepared to pay a greater multiple of current earnings now. So if ’Growco’ also has current earnings per share of R5, it might have a current share price of R100, based on its growth prospects. These growth prospects would be signalled by its PE of 20 (R100/R5). So how do you know if a high-PE company is worth investing in? To answer this question, we need to look at…
Potential pitfall #2: Forward PEs
Sell-side analysts are fond of downplaying a share’s high PE (and high price) by calculating a ’Forward PE’. We can understand this by considering the example of Growco, with its PE of 20 and current earnings per share of R5. However, analysts might point out that Growco has a forward PE of just 12.5, which is (say) in line with or slightly above the sector average.
This implies next-year earnings of R8 per share, a 60% increase on the current year (R100/R8 = 12.5). We have assumed a one-year forward projection of earnings, but forward PEs can be based on one-year or even five-year forward-earnings projections. And of course, the further into the future the projections, the more uncertain their accuracy.
Behavioural economist Daniel Kahneman has shown that overconfidence, and an under-appreciation of the complexities of their environment, cause most financial analysts to produce very poor forecasts of the future. So if forward PEs are questionable, how can we determine what a company’s PE should be? We’ll look at this question next.
Calculating expected PEs
Three factors drive a company’s PE ratio: The rate at which it can grow its annual earnings and FCF; the percentage return it can earn on new capital invested into the business (i.e. reinvested profits); and the rate of return required by the company’s shareholders (its cost of capital).
To illustrate this point, let’s take the example of Excello and Slowco. Both companies have the same cost of capital, i.e. 10%, both grow their annual earnings and cash flow by 5%, but Excello earns 20% per annum on reinvested profits, compared to Slowco’s 10%.
To calculate their PEs, we can use the following formula:
PE = 1 – g/r
k – g
g = the long-term growth rate in earnings and cash flow
r = the rate of return earned on new investment
k = the company’s required rate of return on equity (cost of capital)
It can rightly be argued that the long term growth rate in earnings and cash flow can be difficult to forecast, and that the above method might be better suited to experienced and suitably qualified financial analysts. However, relatively unskilled investors might still be able to make use of trailing (rather than forward) PEs to identify promising shares.
Trailing v forward PEs
Experienced financial analyst Joachim Klement of the CFA Institute has investigated the difference between trailing and forward PEs. In a recent study, based on shares underpinning the indices of the USA’s S&P 500, the UK’s FTSE 350, the Euro StoXX 300, and Japan’s Nikkei 225, Klement chose 20% of stocks with the lowest PE ratios, and 20% with the highest PEs.
Going back monthly for twenty years, he then compared the monthly returns of the two groups. He first of all used trailing (historic) PEs, going back 12 months, then switched to forward 12-month PEs. Forward PEs were based on consensus earnings forecasts extracted from the Institutional Brokers’ Estimates System.
On all four exchanges, the cheaper stocks chosen on the basis of trailing PEs, outperformed the more expensive stocks selected on the same basis. And in all cases, the outperformance was greater than that obtained by cheap versus expensive stocks, chosen on the basis of forward PEs.
Although Klement did not test the South African market at all, a respondent to his online article noted that he had conducted a similar study on the JSE, starting in the 1960s, and had produced results which were ‘in broad agreement’ with Klement’s findings.
The PE is a quick and user-friendly means of assessing a share’s value. However, low PEs can indicate value or a company in trouble, whereas high PEs can point to exciting growth prospects or an over-valued company. In all cases, PE evidence should be followed up by a more in-depth analysis of the companies concerned. And remember, whatever else you do, don’t rely on forward PEs!
AJ is an academic and a freelance financial journalist who has written for Sharenet for some 15 years. He spent 25 years as an accountant and financial manager in various South African companies before moving into academia. He has a broad range of interests, including all aspects of business and stock market investing. Apart from a bachelor’s degree in Accounting, AJ holds a Master’s degree in Financial Management. He is also a Fellow of the Chartered Institute of Management Accountants.