PE ratio

[zyreon]

Just been reading "The Dark Side of Valuation" by Damodaran, some interesting thoughts on the PE ratio...

Normally for most people when they see the PE ratio they think price per share divided by earnings per share. While this is correct it is a simplistic way of seeing it and loses all the details of the real factors that comprise the PE ratio and some of the fundamental drivers of value.

For an alternative look at the PE ratio try this:

PE = DPR*(1+G)/(R-G)

DPR = dividend pay out ratio (DPS/EPS) [dividend per share/earnings per share]
G = growth rate
R = required return/cost of equity capital

The above three elements contain the three key drivers of value:
DPR = cash flows
G = growth
R = risk

Thus, while it is intuitively obvious that these three factors should be important - in the above formula you can see how they can be demonstrated to drive value.
Specifically, higher cash flows, higher growth and lower risk lead to a higher PE ratio.



Additional notes:
G = Growth
A simple method of calculating the sustainable growth rate is produced from the ROE and the retention rate i.e. G = ROE*(1-DPR) thus the logic is that any earnings not paid out as dividends will be retained and reinvested at the current ROE (so assumptions apply, but in theory it kinda makes sense).
R = Required return
Usually this is derived from the CAPM i.e. R=Rf+B(Rm-Rf) where Rf = risk free interest rate B = Beta and Rm = market return. Thus the CAPM takes the risk free rate and adds a risk adjusted market risk premium to it - so you can see that the Beta is the proxy for risk in the PE model above.

[Lizard]

Hi Zyreon,
Your P/E ratio is a valuation tool in terms of determining an appropriate share price rather than a measurement of the actual P/E. Equivalent to using the constant growth dividend discount method - although I think DDM tends to use expected growth in dividends, which does not necessarily match your (sensible) equation.

In my view, these types of equations probably only work well for large companies with a consistent operating history and a stable balance sheet (and therefore representative historical data). Very few NZ companies would fall into that category. In terms of actual use, I would suspect pure use of such an equation (on appropriate stocks) in the current investment climate would direct you towards stocks which had had a very successful run over the past decade and were now approaching a less favourable outlook. These stocks would most likely be the ones to appear cheap, as investors would be selling at below the value indicated by past performance.

It is interesting that the market still clings to P/E as a measure - EV/EBITA, with its incorporation of balance sheet, would seem more sensible as a screening/selection tool. But I have yet to find an easy data source for this.

[zyreon]

Valuation is about trying to estimate a value based on the future - and I agree this can be easier for more established companies - however when you come up against new technology firms such as those around the dot.com boom the fundamentals are still the same. It just becomes more complicated, it comes down to trying to put together a set of reasonable estimates, and sometimes this produces valuations that are way out of line with the market... and during the dot com boom this meant the market implied variables were simply unrealistic (i.e. you could instead go to the market and get the stats and find implied figures e.g. 100=.20/(X-10&#37 etc).
You are quite right about it being a multiple derived from the DDM (where price=dividend per share/(R-G)) - I like it because it breaks things down, yet remains relatively simple.
My only concern with using EV/EBITDA is that it is a firm valuation method - which is fine if you're planning an LBO but if you're only looking at it as an equity investor then you need to look at equity valuations instead... however it could be used for selection purposes by identifying potential candidates for LBO/M&A and speculating appropriately...

[Lizard]

Zyreon,

Here's a few of my thoughts on valuation:

1. Valuation is useful, but different types of valuation technique serve better with companies at different stages of maturity and in different industries. In developing companies, investment comes first, then revenues are produced, then profits, then dividends. The basis for valuation is something which should be matched to the stage.
   
2. Consideration of the balance sheet is essential to any form of valuation - buying "value" alone is likely to direct you into distressed businesses or situations where existing equity is more likely to be diluted. It also misses companies that are positioned to invest in explosive growth.
   
3. Valuation should always be forward looking. Seems obvious, but the temptation is to apply formulae which automatically generate a value based on historical data.
   
4. Value in itself is not a reason to buy. The primary criteria should more often be "a good business" with consistent management, good ROA, in a rising market sector and with a competitive edge.
   
5. Valuation can demonstrate that buying a business with sustainable high levels of earnings growth will mean there is no price too high for a long term holder. This is a valid conclusion - but not always the most profitable thing to do in the short term.
   
6. Valuation always needs to be considered in the light of market conditions. Profit margins of greater than 20% rarely last. And high returns on assets make a sector attractive for competition.

[Lizard]

Um, I hope I haven't killed a very good thread by Zyreon here - I really don't know much about this stuff. Next please. :o

[steve fleming]

Um, I hope I haven't killed a very good thread by Zyreon here

Well you gave it a pretty good punch in the head, Liz...but looks like mine was the killer blow!

[zyreon]

heh, been out... Yep good points there.

I think it is a mistake though when people say that you need to look beyond the numbers - because at the end of the day your numbers must actually take into account things like competitive landscape, business life cycle, management quality, and so-on and so-forth. I guess in essence the job of a valuer is to quantify some of these potentially more qualitative factors so that they show through in the valuation. You do need to approach it from many angles and when you have a company where the earnings are negative there may still be plenty of NPV...

Actually I'll post a couple more formulae from the book
PS (price to sales) = [net profit margin x DPR x (1+G)]/(R-G)
PBV (price to book value) = [ROE x DPR x (1+G)]/(R-G)

Obviously you can use the above two multipliers where there is no current positive earnings...

[stephen]

"EV/EBITA, with its incorporation of balance sheet, would seem more sensible as a screening/selection tool. But I have yet to find an easy data source for this."

That sounds like one of the criteria in the "magic formula" described in the __The Little Book That Beats The Market__.

I am working on a screening tool for the ASX and NZX using these principles. The data IS out there, eg on Yahoo finance - it's just a question of aggregating it, and that's not actually hard to do.

[Snoopy]

Here's a few of my thoughts on valuation:

In current market circumstances where good companies are getting trashed when earnings growth does not fulfill sharemarket expectations, I think it is appropriate to take another look at elements of Liz's valuation list.

Consideration of the balance sheet is essential to any form of valuation - buying "value" alone is likely to direct you into distressed businesses or situations where existing equity is more likely to be diluted. It also misses companies that are positioned to invest in explosive growth.

Buying a share on any one (and only one) indicator is always going to get you into trouble in the end.

If by buying 'value', you mean buying just because a share price is low, or PE is low, I would agree. But I wouldn't agree with 'value' being measured on a one dimensional scale. So I can't agree that 'value' companies are likely to be distressed, or likely to need new equity.

The one exception to this rule is companies that constantly need access to new capital to grow or even retain their current profitability. In that instance, and this includes all finance companies, a falling share price means 'stay away'.

Generally IMO a battered down share price is not a good indicator of a business in long term distress.

Buying 'value' will almost certainly see you miss out on buying companies poised for 'explosive growth' that is true. But value buying also protects the investor from the PE slashing that can halve or more a company's share price when 'explosive growth' is expected but not realised - on no change of *actual* earnings.

Thus I see missing out on buying those 'explosive growth' opportunities to be a good thing.

Valuation should always be forward looking. Seems obvious, but the temptation is to apply formulae which automatically generate a value based on historical data.

Valuation can demonstrate that buying a business with sustainable high levels of earnings growth will mean there is no price too high for a long term holder. This is a valid conclusion - but not always the most profitable thing to do in the short term.

So what you are saying here Liz is that to invest in 'explosive growth' opportunities you have to make up some growth factor (not use a historical projection) and it is very likely that, in so doing, you will convince yourself of the investment case? [since no buy price will be too high if your made up optimistic (why would you invest if you were not an optimist?) projection is right]

Valuation always needs to be considered in the light of market conditions. Profit margins of greater than 20% rarely last. And high returns on assets make a sector attractive for competition.

Just to make things perfectly clear, I believe you are talking about business market conditions not investor market conditions, vis a vis the current state of the sharemarket.

If that is what you mean I agree.

This is why I have balked at increasing my investment in Turner's Auctions over recent months. Not because I didn't believe in the ability of the company to manage its way out of difficulties. It was because I could see the overall second hand vehicle market was experiencing a 'dislocation shock' of a 'once in a decade' magnitude and I wasn't clear how the up until now business model would stand up in those conditions.

As it turned out my fears seem unfounded and I should have piled into the share as it traded under $1- arrrgh! Or perhaps not. At that stage the full year TUA result and business market outlook was not out. So I would have been taking a serious gamble if I had started buying at those sub $1 prices.

As always it is easy to appear clever if you have the benefit of hindsight. Sorting out 'share filters' in advance given you only have historical data to go on is much more difficult!

SNOOPY

[Lizard]

So I can't agree that 'value' companies are likely to be distressed, or likely to need new equity.

This thread referred to measurement of "value" using P/E and various associated ratios. I would suggest that if I screened the market for stocks and looked for the ones with the lowest P/E, P/S and Pr/NTA ratios (often considered to be measures of value) then I would find the top 10 (i.e. the lowest ratios) was heavily laced with companies that are either about to go broke or to re-finance with heavy dilution. So using these tools to screen stocks tends to get me into trouble unless I take my analysis alot further.

However, maybe in the lows of a bear market, these screening ratios will be more useful than in the picked over bones of an old bull.

Buying 'value' will almost certainly see you miss out on buying companies poised for 'explosive growth' that is true. But value buying also protects the investor from the PE slashing that can halve or more a company's share price when 'explosive growth' is expected but not realised - on no change of *actual* earnings.

And a share that looked to be on a low P/E can easily become a share with a high P/E if my analysis was wrong and the company's earnings decline. ALL shares that disappoint against predictions suffer accordingly, no matter whether they were previously in an uptrend or a downtrend; had a high P/E or a low P/E. If a growth stock turns out to be growing more slowly, then, so long as it continues to grow, it should eventually return my money with interest (assuming a neutral market). If a low/no growth stock turns out to be doing worse than expected, then that probably means that if I hold long enough, I will have nothing left.

So what you are saying here Liz is that to invest in 'explosive growth' opportunities you have to make up some growth factor (not use a historical projection) and it is very likely that, in so doing, you will convince yourself of the investment case?

Not necessarily. I could look at historical return on assets, combine with the balance sheet and payout ratio to determine a sustainable rate of possible growth as my "growth factor". Although this alone might fail me where there are changes in sectoral conditions, or where the business is subject to economies of scale. Or where the business model has changed.

(Whether or not I am easily convinced about the business case will probably depend on my mood, on who is suggesting it to me and on the number of drinks I have had).