## Thursday, 22 April 2010

### Understanding The Intricacies Of Price–Earnings Ratio

By Ernest Lim

Readers may be surprised why I am writing an article on price-earnings (PE) ratio, as it is one of the oldest and widely known ratios around. They are often quoted by analysts, stock brokers and readers. Most people know how to calculate a PE ratio and they know that a low PE signifies that the stock is cheap and vice versa. However, is this really the case? Should one buy a low PE stock over an average PE stock? Or should we consider other factors? These are the intricacies, which I will explore in this article.

What is PE ratio?
PE ratio means how many times current year’s earnings1 that investors are willing to pay for the company stock. For example, according to my estimates, China Gaoxian FY10F PE is only around 3.0x. This means that investors are only willing to pay about 3x Gaoxian’s current year earnings (i.e. FY10F earnings) for Gaoxian stock. In other words, it reflects the confidence that investors have in the stock. Is this a sure signal that Gaoxian is undervalued? I will discuss more on low PE stocks in the paragraphs below.

PE ratio – how to calculate?

For readers who are unaware on how to calculate PE ratios, I have listed two usual ways below to calculate them.
• Market price of the company (i.e. market capitalization) / net income of the company; or
• Price per share of the company / earnings per share of the company

Interpretation of PE ratio

The PE ratio is meaningless by itself. We have to examine it using the following two common techniques.

Comparison with industry

We can either compare the PE ratio against that of individual companies, or against an average PE of firms in similar industry. There are two general points to note. Firstly, if the company is trading at a lower PE than its peers, it is cheaper than its peers. Secondly, different industries have different PE ratios. This is because some industries either experience higher growth rates, or stable growth rates with lower risk, thus they are able to sport higher PE ratios.

Comparison with time

The company’s PE ratio is compared against a three, or five, or a ten year time period to determine whether it is priced cheaply against its historical valuations. We should be cognizant not to use a period which is too short (i.e. < 3 years) as it may not have captured the entire business cycle of the company. Furthermore, the PE ratio may be affected by extreme events. For example, the PE ratios of most companies slumped to single digit levels between 2008 and 2009.

However, if we were to compare the ratio against a fifteen year data, it may be too long. The industry dynamics or the company’s fundamentals may have evolved over time. In my opinion, I will use either a five or ten year time period.

Reasons for a low PE

Oftentimes, I hear readers express disbelief on stocks which have extremely low PE ratios. There may be several reasons why a stock has a low PE ratio. Below are some of the reasons.

Growth – an important component

A stock with low or zero expected growth in its future earnings per share is unlikely to be ascribed a high PE ratio. Thus, PE ratios should be complemented with another ratio called “Price earnings to growth ratio”

(PEG). This is calculated in the manner below:
PEG = PE / growth rate in annual earnings per share

Generally,
If PEG ratio < 1, company is undervalued.
If PEG ratio > 1, company is overvalued.

Therefore, besides looking at PE ratio, one has to take into account of the company’s growth rate to determine whether the company with the low PE is justified.

Incompetent or dishonest management

Firstly, I believe most readers would agree that the quality of the management is critical to the long term viability of the company. If management is incompetent, it is very difficult for the company to consistently generate an above average return on equity. It is more likely that over the long term, the incompetent management may have destroyed shareholder’s value. Thus, it is justified for the stock with poor management to have a low PE ratio.

Secondly, a company which has, or just had accounting irregularities before will command a lower PE ratio. This is because investors would have doubts on its financial figures (e.g. earnings), and consequently give a lower PE ratio to the stock.

Poor communication with shareholders

Usually, an outstanding company may have a low PE, simply because investors do not understand the company well. This is due to inadequate communication between the management and the shareholders. Some companies’ management may view that it is sufficient just by doing their business well and they are unlikely to spend additional time to engage with the shareholders and the investment community. Some management may believe that value speaks for itself. However, for listed firms, it is unlikely that pure devotion to work can deliver outstanding stock returns and high PE ratios for the firms. This is because if shareholders and the investment community do not understand the companies, it is difficult for them to feel confident on the companies’ earnings and prospects, and this will affect the PE ratios that the companies can command.

Temporary downturn in the company or industry

A company may have experienced one or two quarters which is poorer than analysts’ estimates and investors may punish the share price, sending its PE to a figure which is lower than its peers. For this company, it would be good to do some detailed fundamental analysis to ascertain whether this sub par performance is permanent or temporary. If the company has just hit some temporary obstacles, which resulted in posting poorer than expected results, then it may be good to start to accumulate the stock if investors believe that the company can turn around soon.

Separately, a great company may have a low PE in an industry which is facing lackluster growth rates. This is because investors (rightfully) believe that it is generally difficult for a company to post above average earnings growth rate in a poor industry. However, there is one exception to this. If the company, such as China Gaoxian, is sporting a low PE ratio in an industry, which is starting to rebound from the trough, it may be a good idea to accumulate in this company.

PE ratio – May be subject to manipulation

Readers should be aware that PE ratio is a function of price and earnings. Earnings are based on accounting principles and thus the choice of accounting principles would have an impact on the earnings. For example, given the same assets, net income for company A will change depending on whether he uses a straight line depreciation for its assets or a double declining balance method. Thus, the quality of the PE ratio is dependent on the quality of earnings.

Conclusion

Although the PE ratio is one of the most widely known ratios around, it is pertinent for readers to understand the intricacies in the application of the PE ratio. By doing so, the PE ratio will become another effective tool in the investors’ armoury in finding good investment opportunities.

1 It depends on the type of earnings used in calculating the PE ratio. It can be historical, or current, or future earnings. In my example, I have used China Gaoxian’s FY10F earnings per share, thus the earnings used is current year’s earnings.

Ernest Lim currently works as an assistant treasury and investment manager. Prior to this role, he was with Legacy Capital Group Pte Ltd, a boutique asset management and private equity firm, as an investment manager since 2006. He received a Bachelor of Accountancy (Honours) from Nanyang Technological University in 2005. He is a Chartered Financial Analyst, as well as, a Certified Public Accountant Singapore. He is currently taking a short break before embarking on a new role.

http://www.sharesinv.com/articles/2010/04/16/intricacies-of-pe-ratio/

Comment:  An excellent article on PE