- P/E = Stock Price / EPS
- It is the most widely used metric as a measure of how expensive or cheap a stock is. It have been used in valuation reports by stock analysts and investment bankers.
- It vary across sectors - some sectors have high P/E while some have low.
- Generally, stock trade at low P/E than other stock in same sector must be misprice
Which "EPS"?
- · Is it the EPS of the most recent financial year?
- · Is it an undated measure of EPS by adding up the latest four quarters results?
- · Is it the expected EPS for the next financial year?
- · Is it before or after the extra-ordinary items?
- · Is it based on the outstanding number of shares or all shares that will be outstanding when all warrants or ESOS are converted (fully diluted)?
Why different P/E?
- Every company (even those in the same industries) contain unique variables, e.g.
- growth
- risk
- cash flow patterns
- Company A and Company B should have same P/E?
- Company A has poor operating efficiencies, no potential growth, a poor balance sheet
- Company B has superior earnings and cash flow growth, and a healthy balance sheet.
- Company with strong market position in general generates more stable earnings should be accorded with higher P/E ratio.
P/E vs Mr. Market
- P/E ratio serve as proxt to reflect market moods and perceptions
- This can be viewed as a weakness, especially when markets make systematic errors in valuing entire sectors.
- Below figuee shows the PE ratio distribution of S&P500 stocks on 31st December 2013. Most stocks are now trading above a PE of 16. Hence a PE ratio of less than 16 may be good, below 8 will be fantastic, but above 20 may be too expensive.
P/E ratio:
Theoretical background
- The financial theory postulated by John Burr Williams in his “The theory of investment value” says the value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate. The simplest model for this purpose would be the Gordon constant dividend growth model for a stable firm.
- Eq 1: P0 = DPS1 / (r-g)
- P0 = Value of equity
- DPS1 = Expected dividends per share next year
- r = Required rate of return on equity
- g = Expected growth rate in dividends (forever)
- Divide Eq 1 by Expected EPS next year, Eq 2: P0 / EPS1 = Forward PE = (DPS1 / EPS1) / (r – g ) = Expected payout ratio / ( r – g ) Equation 2
- From Eq 2,
- A higher growth firm should have higher P/E.
- A higher risk firm having a higher cost of equity ,r , will have a lower P/E ratio
- P/E should increase when the payout ratio increases.
- Firms that are more efficient about generating growth by earning a higher return on equity will trade at higher multiple.
- Eq 2 only applicable for firm with stable growth, for a high growth company, you would have to estimate the payout ratio, cost of equity and the expected growth rate in the separate phase of high growth and the stable growth period, and summing up the value in these two phases taking the time value of money into consideration. This approach is general enough to be applied to any firm, even one that is not paying dividend right now.
Investing using the low P/E
ratio strategy
- Basing on P/E ratio alone is not a desirable way as P/E ratio theoretically depends on a number of factors.
- Low PE stocks are riskier than average and that the extra return is just a fair compensation for the additional risk, low future growth rates and poor quality earnings.
- Additional screening criteria for low P/E stock
- Low P/E ratio with respect to the prevailing market, say not more than 12
- Low idiosyncratic risk as measured by
- debt/capital ratio < 0.6
- current ratio of more than unity
- interest coverage ratio > 3.
- Reasonable expected growth in earnings > 5%
- Historic growth rate in past 5 years > 5%
- Good quality of earnings with reasonable cash flows
Estimating fair PE ratios from fundamentals
- Katsenelson’s absolute P/E method to find a fair value of P/E ratio for a specific firm.
References:-
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