From the pen of Karin Iten…

Dear Investment Academy Reader,

The price earnings (PE) ratio crops up everywhere, from newspapers to websites to analysts’ reports. But just how reliable is it as a valuation measure? Today MoneyWeek strategist, Tim Bennett, explains why…

A quick refresher

The PE ratio is deceptively simple.

In its most basic form it compares a firm’s share price (for ordinary rather than preference shares) to a year’s earnings (profits after tax but before dividends).

Take a firm with a share price of R3.00. It made an after-tax profit of R4m last year and has eight million shares in issue. Earnings per share (EPS) are R4m/8m, or 50c.

So the historic PE ratio is R3/50c, or six times.

If next year’s profits are expected to come in at R6m, then forecast EPS, assuming no new share issues or buybacks, is R6m/8m, or 75c. So the forward PE is just four (R3/75c). In other words, if profits stayed static each year, it would take you four years to earn back your original investment (not adjusting for inflation).

What’s the point?

A PE ratio can suggest whether a share is cheap or pricey. As Jack Hough notes in Smart Money, US stocks “have traditionally traded at about 15 times yearly earnings”. The higher the ratio, the longer you’ll wait for a return and the more the chance of disappointment. For example, says Hough, a US stock trading on 21 times earnings will “earn back its principal” in about 15 years (assuming earnings compound up, like interest on a bank deposit). Trading on 15 times earnings, they’d take nearer ten years.

As for judging whether a PE is high or low for a particular firm, benchmarks to use include past years, the firm’s peers and sector as a whole, and the wider market – the JSE All Share Index.

A forward PE should usually be more useful than a historic PE – future earnings are more relevant to an investor. Unfortunately, analysts are dreadful at getting forecasts right. Besides which, both measures suffer other flaws.

When a PE will let you down?

Conventional PEs can let you down in at least four ways. First, a single-year PE is a snapshot based on one year’s earnings. That makes it an unreliable guide to future performance for a cyclical firm with volatile profits.

Next, earnings aren’t equally important in analysing all industries. In investment trusts or property sectors, net assets under management tend to matter more. That means other ratios, such as the price/book ratio (the share price as a multiple of the book value of a firm’s assets per share), are more relevant.

Thirdly, the PE tells you nothing about cash flow and hence dividends. Profitable firms that don’t manage their cash flow properly can go bust – a PE may give you little advanced warning.

The ratio also reveals nothing about the proportion of annual profits paid out as a dividend, or whether current dividend policy can be maintained.

Fourthly, it is a hopeless measure for a firm making losses, as you have no earnings figure available. Analysts try to correct for this by looking at other measures, such as the price/sales ratio (the share price as a multiple of one year’s turnover). But in many cases the best bet is to look at a firm’s earnings across an entire business cycle.

What to do

We recommend “good defence rather than offence”. Short term, that means “tightening trailing stops (if you have an automatic stop-loss order triggered by, say, a 25% drop in a share price, reduce it); selling overpriced positions (stocks with above average PEs), and shrinking the size of your bets”. To that we’d add sticking to good-value, income-paying, defensive blue chips. In a toppy market, they’ll deliver the best night’s sleep.

Happy investing!

Tim Bennett,
for the Investment Academy