Price-to-earnings ratio and its use as an investment strategy

by KC Chong

“The key to successful investing is to relate value to price today.”

PE ratio is the most widely used metric as a measure of how expensive or cheap a stock is. Analysts and investment bankers use this valuation metric in their valuation reports all the time.

Price-earnings ratios vary across sectors with stocks in some sectors consistently trading at lower P/E ratio than stocks in other sectors. It is generally acknowledge that stocks that trade at low P/E ratios relative to their peer group must be mispriced.

P/E = Market price / Earnings per share (EPS)

The widely used of P/E ratio to gauge the attractiveness of a stock is often justifiable as given below:

• ·       it is an intuitively appealing statistic that relates the price paid to current earnings.
• ·       it is simple to compute for most stocks, and is widely available, making comparisons across stocks simple.
• ·       it is a proxy for a number of other characteristics of the firm including risk and growth.

One big problem with P/E ratio is which “EPS” is used.

• ·       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)?

Consider this case of internet stocks at the end of the 20^th Century. All telecom and internet stocks were trading at P/E multiples of high tenths or even more than hundred. If a particular internet stock is trading at a P/E ratio of say 50, was it considered cheap? I don’t.

Besides that, all companies, even those in the same industries, contain unique variables - such as growth, risk and cash flow patterns. Surely a company which has poor operating efficiencies, no potential growth, a poor balance sheet should not be accorded a similar P/E ratio with one which has superior earnings and cash flow growth, and a healthy balance sheet. A company with strong market position in general generates more stable earnings should be accorded with higher P/E ratio.

P/E ratio is hence more likely to reflect market moods and perceptions but this can be viewed as a weakness, especially when markets make systematic errors in valuing entire sectors.

Figure 2 above shows the PE ratio distribution of S&P500 stocks on 31^st December 2013.

As you can see above, 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.

Estimating fair PE ratios from fundamentals

One way for the practitioner to do to solve this problem is to use the Katsenelson’s absolute P/E method to find a fair value of P/E ratio for a specific firm which we will discuss further later.  

Here we will look into a theoretical view of how P/E ratio is related to metrics such as return on equity (ROE), dividend payout, growth, cost of capitals etc.

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.

P₀ = DPS₁ / (r-g)                     Equation 1

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 both sides of Equation 1 by expected earnings per share next year, EPS₁

P₀ / EPS₁ = Forward PE = (DPS₁ / EPS₁) / (r – g ) = Expected payout ratio / ( r – g )                           

Equation 2

Equation 2 shows that:

·       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.

Note that the above equation 2 is the fair PE ratio for a stable growth phase. 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

Tons of research has shown that investing in low P/E ratio stocks have yield extra-ordinary returns when compared to the broad market. However just basing on P/E ratio alone is not a desirable way as P/E ratio theoretically depends on a number of factors. It is possible that these 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. One can improve the strategy tremendously with some screening works based on the discussion above as below.

• Low P/E ratio with respect to the prevailing market, say not more than 12
• Low idiosyncratic risk as measured by debt/capital ratio, of less than 0.6, current ratio of more than unity, and interest coverage ratio of more than 3.
• Reasonable expected growth in earnings of more than 5%
• Historic growth rate in past 5 years of more than 5%
• Good quality of earnings with reasonable cash flows