I remember when I started investing, people (or some books) used to tell - anything that is above 8x PE is considered expensive. That practice is still within some Malaysian VCs, investors where they would even look at prospective PE of 3x - 5x. Is this archaic measurement realistic?
Times change, appetite changes as well. However, if one is to look at the global interest rate trend, starting with the US Fed Funds rate - where it has come down from a high of almost 20% in 1980 during the Volcker period to now post-2008 subprime crisis where the Feds are keeping rates at almost zero, should it signify something?
Similarly, Japan has even kept rates at zero for much longer period, basically for the entire 21st century thus far (see below).
In Malaysia, I am pulling out the time (fixed) deposit rate where it has dropped from above 8% to hovering around 3.0% to 3.5% for more than 10 years now, where does one expect to put their money? - in FD still? Would one's risk appetite be higher investing into stocks, properties, even commodities etc? Surely.
If one has a higher risk appetite, due to the low deposit rates together with low financing rates from banks - would the accepted average PE generally be higher? Again surely.
If one is to look at the general trend from US to EU to Japan as well as in a period where funds are able to move freely, would you think that these funds would look at opportunities all over the world? It is much easier for some of the funds to get financed from a low interest rate country and invests their money in any investments that would get them anything that would provide between 8% to 10%, sometimes lesser - assuming currencies exchange does not change much.
So, what's the right PE? Anything that provides me higher than the 3.4% what banks is giving me, or for some bigger funds - anything higher than high quality bonds, with a little bit of buffer.
With that wouldn't you think that any business that has a good consistent growth, a PE of somewhere between 15x to 20x, be even digestible?
Or someone has a crystal ball and can see that interest rates are moving upward fast in the near future?
12 comments:
2 things in my view:
1) P/E, at least to me, is an absolute way of valuation, never a relative one. Buying at 5x P/E means 20% earnings return, which is a brilliant investment in any case. In contrast, buying at 20x P/E means 5% earnings yield, which is unattractive unless a guaranteed-growth of >50% is in place. Sure, low P/E may not yield capital gain immediately, but it will come eventually if the company is good.
2) Comparing the interest rate with P/E, in my view, is only applicable to overall stocks market and not individual stocks. In that way, our KLCI is standing at 6% earnings yield (16.7x P/E) compared to the 3.5% interest rate (or 4% in the near future). The 2.5% premium is okay but I guess the room isn't attractive enough for big-appetite investors. I will be very concern if KLCI touches 20x P/E.
(I hope I'm not stating the obvious)
When I was working as a VC we always tried to strike deals at PE of 4 or 5 based on projected earnings for mezzanine stage companies and PE 8 to 10 for pre-IPO deals. Of course there are variations according to type of industry and negotiation with the business owners, but generally that was the rule of thumb.
When companies go public, PE is determined by "market forces", and theoretically we all know PE reflects the future growth potential of a company where the higher the PE the higher growth rate is "expected" of the company in the future.
For me PE in actual investments is only good as a gauge for comparing historical trading PEs and comparing against similar companies within the same industry. Investing in low PE companies DOES NOT equate to higher returns and the same for higher PE companies. Returns are only realized through capital gains and dividend returns which are a reflection of how companies perform fundamentally against market expectations (fundamentalist speak). In reality I think the expectations of how a company performs play the bigger role in share valuations.
I can go on and on about PE, but for me its only one number to look at among many other things when investing. When I was doing my finance degree I thought the world of PE but after so many years, I mostly just glance through when investing. For me there's no PE too low or PE too high. Its all your own foresight against the general perception of the market all the time.
The economy, interest rates, bond prices and equity prices are closely related. Interest rate sensitive investors tend to switch between bonds and equity to maximize earnings, but I don't believe that low interest rates drive up equity prices. Japan had zero interest rates for many years and yet its economy and share market was in the doldrums until abenomics came along. In fact equity does well when the economy does well where interest rates are higher due to inflationary pressures. The notion of borrowing cheap to buy equity is only true if you believe that the economy will improve.
Despite all the financial mumbo-jumbo I know, I'd probably be a better investor if I played more online games instead. Check out this interesting article if you haven't yet.
http://www.bloomberg.com/news/2014-09-25/mystery-man-moving-japan-made-more-than-1-million-trades.html
Agree dt, when it comes to investing, one need not rely too much on short to medium term mart & macro economic condition. One would have better chance of making decent returns, if he/she, just stick to the buy & hold method, or at least be fully invested in fundamentally sound shares - all the time. Small time investors shouldn't try to predict economic recessions and market over valuation, they should just concentrate on individual counters instead. Even Buffett - the biggest investor of 'em all, has warned against market timing/outsmarting!
Fully Agree that PE is not the main criteria into an investment. More importantly, is the people behind the company. I always believe that if you cannot trust the person, avoid. Then there are whole host of things, prospects, competition, positions of the company etc.
This article is however talking about the general appetite for risk as there is a topic most people would like to talk about, "Margin of Safety."
How does one measure that?
I agree that MOS is the core strategy of stock investment and therefore it should be protected like a secret recipe, especially for those who are going to use the same formula to snowballing their wealth. Telling the formula and what stock you're buying is like telling someone your credit card number plus the security code, when you have tens of thousands to invest in a low volume stock or if you have millions to invest in a medium volume stock.
I can't tell my secret recipe because I think I'm going to use it for many years until it fails to function. However the minimum acceptable level would be positive cash flow (dividend) in the future less financing cost at present interest rate. Dividing the net gain by your sum of investment is the ROI. Your MOF grows over time as an effect of compounded ROI. The weakness of this model is that it is inaccurate for longer period (say above 5 years) because of environmental change, and it also does not consider business plan that would change the fundamental of business drastically, for example, expansion of capacity, entering into a new market, impact of new technology, impact of new government policy or rules, etc.
The condition to apply MOF successfully is that one must accept that he could only be generally right (buy at attractive or reasonable price) and never waste time and opportunity (precisely wrong) trying to buy at lowest price. And then, his patience must last at least 3 years plus a margin of safety for patience that worth another 2 years. Because no any formula can show you the return within one year at high confidence level, trying to do that is like dividing by zero that returns invalid answer.
After all, there is no exact way of calculating MOF. Each one can calculate using their own formula that follow the general principle with some customization according to their rationale. But why bother to be the smartest person? There is no need to be the smartest person to make money. You just need to be above average and make sure the average are greater fools (beggar thy neighbour, just for laugh).
""Prosper thy neighbour"" is the mantra of most investors. They are positive & constructive people. They want others to be successful, because the poor can't consume, contribute...much to the economy and more importantly to their investments. They believe in the "win-win" for all concept. That's why many of them shares their methods & secrets, by selling their books to small investors like me!
So far, i had only read 2 books on the art and technique of investing & speculating.
Kevin, actually there is no secret in stock investment. Majority of educated young people (who knows how to use internet and found this blog) do not invest well not because of the difficult reach to knowledge but the difficulty to copy the diligence and patience of those who are successful.
Agree nixiao100, i, myself had never attended any seminars/courses on investing/trading. Even the 2 books i had read in the mid 90's, wasn't mine - it was my brother's! I also believe nowadays , anyone new to investing, can learn all the art of dividend/trend/value investing, from the web - from free sites at that too!
P/E is the by-product of other valuation methods.
So, one should not look at how to determine the right P/E instead one should look at how to value a business correctly.
Once that is done, the right P/E for that particular business will emerge by itself.
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