PE ratio

[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).

[Snoopy]

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 a lot 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.

I agree that Low P/E *could* mean a company is about to go broke or refinance with heavy dilution. However, there are other financial statistics you can check that will save you choosing a company with such a potential fate. I think to discard low P/E companies, because low PE 'might be bad' is wrong.

Here is a comprehensive reference on buying low P/E companies.

http://www.ftpress.com/articles/arti...70894&seqNum=3

From that particular page I reference, I quote the salient paragraphs:

----------

Low PE Stocks versus the Rest of the Market

Studies that have looked at the relationship between PE ratios and excess returns have consistently found that stocks with low PE ratios earn significantly higher returns than stocks with high PE ratios over long time horizons. Since some of the research is more than two decades old and the results vary widely depending upon the sampling period, it might be best to review the raw data and look at the longest period for which data is available.

Begin by looking at the annual returns that would have been earned by U.S. stocks categorized into ten classes according to PE ratios from 1952 to 2001. The stocks were categorized by PE ratios at the start of each year, and the total return, inclusive of dividends and price appreciation, was computed for each of the ten portfolios over the year.

On average, the stocks in the lowest PE ratio classes earned almost twice the returns of the stocks in the highest PE ratio classes. To examine how sensitive these conclusions were to how the portfolios were constructed, you can look at two constructs. In the first, equally weighted portfolios were created, and an equal amount of money was put into each firm in each portfolio. In the second, more was invested in the firms with higher market value and less in the smaller firms to create value-weighted portfolios. The results were slightly more favorable with the equally weighted portfolio, with the lowest PE ratio stocks earning an average annual return of 24.11% and the highest PE ratio stocks earning 13.03%. With the value-weighted portfolios, the corresponding numbers were 20.85% and 11%, respectively. In both cases, though, low PE stocks clearly outperformed high PE stocks as investments.

To examine whether there are differences in subperiods, let's look at the annual returns from 1952 to 1971, 1972 to 1990, and 1991 to 2001 for stocks in each PE ratio portfolio. Again, the portfolios were created on the basis of PE ratios at the beginning of each year, and returns were measured over the course of the year.

Firms in the lowest PE ratio class earned 10% more each year than the stocks in the high PE class between 1952 and 1971, about 9% more each year between 1971 and 1990, and about 12% more each year between 1991 and 2001. In other words, there is no visible decline in the returns earned by low PE stocks in recent years.

Thus, the evidence is overwhelming that low PE stocks earn higher returns than high PE stocks over long periods. Those studies that adjust for differences in risk across stocks confirm that low PE stocks continue to earn higher returns after adjusting for risk. Since the portfolios examined in the last section were constructed only with stocks listed in the United States, it is also worth noting that the excess returns earned by low PE ratio stocks also show up in other international markets.

--------

End quote

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.

Yes except that a stock with a low P/E has probably *already* disappointed the market. So there is less chance of a low P/E stock not meeting favourable market expectations. With a low PE stock, I am thinking of TUA as a recent particular example in my portfolio, they recently declared a net profit from continuing operations down some 25%. Following that declaration the share price promptly *gained* 25%, simply because although the result was bad, it wasn't as bad as people thought.

If you start on the bottom rung of the ladder, you often don't have as far to fall.

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.

Most 'bad businesses' are cyclical. It is quite rare that a well capitalised business that is nevertheless operating in a difficult environment goes down.

I do tend to invest in low(er) PE shares myself. As an exercise I have done a bit of analysis on Scott Technology which I had thought of as a 'relatively low PE' share. However on going over my data I have found my idea was quite wrong. The PE, as at September 30th leading up to the annual result, has varied enormously from a low of 11.2 to a high of 200!

I therefore have the basis of a small study. I have only nine years of data points - not enough to claim any result really means anything. But I think you will find the results interesting nonetheless.

I have calculated the return on a year on year basis going forwards (capital gain and dividends) and got a percentage return. I have then compared the return with the market PE prevailing just before the year studied. The results are as follows:

Prevailing PE Ratio     Total Annual Return

       11.2                         +31.5%
       12.2                         -48.5%
       13.0                         +30.6%
       14.8                         +53.6%
       15.2                          +7.6%
       22.7                         -24.0%
       40.3                         +71.7%
      195                           -20.6%
      200                            -2.5%

This is not an absolutely clear cut picture. The very best result occurred when the PE ratio was 40.3 (high) and the worst result occurred when the PE was 12.2 (quite low). The overall picture, though, paints with the opposite brush. On 80% of occasions a low PE is the portent to a good investment result while a high PE is a strong indicator of doing badly. That does not contradict the premise that 'most of the time' - if you screen out the companies in trouble (an important qualifier) - a low PE investment will outperform a high PE investment.

SNOOPY