The price paid for a company is just as important as the quality of the company.
Rule of Thumb:
PE above 11: Market expects positive growth
PE at 11: Market expects zero growth
PE below 11: Market expects negative growth
Showing posts with label PE Ratio and growth. Show all posts
Showing posts with label PE Ratio and growth. Show all posts
Wednesday, 11 April 2012
Tuesday, 22 March 2011
Don't be a stockpicking monkey, mistaking skill for luck. Learn DCF and PER 101.
Don't be a stockpicking monkey
Greg Hoffman
March 21, 2011 - 12:06PM
Monkeys are great stockpickers. Had your common-or-garden variety primate randomly selected five stocks in March 2009, chances are it would now be sitting on huge capital gains, contemplating reinvesting them in bananas - by the truckload.
It's easy enough for us to see that our monkey, who now sees himself as a future fund manager, is mistaking skill for luck. What's harder for us to see is how we might be making the same mistake ourselves.
If examining your portfolio's returns over the past few years engenders in you a feeling of self-satisfaction, you're running that risk. With the sharemarket falling recently now is the time to educate yourself. Consider what follows a lesson in fire safety.
Value investing is theoretically simple: buy assets for less than they're worth and sell when they approach or move beyond fair value. So too are valuing assets: discount future cash flows back to today at an appropriate interest rate for the life of the asset. The discounted cash flow (DCF) model is a commonly-used tool, hammered into every finance and business student.
But DCF models quickly deteriorate when they meet a rapidly changing world. The fact that most analysts failed to consider the impact of falling US house prices on their models played a major role in triggering the global financial crisis. Worse still, the misleading precision imbues investors with unwarranted overconfidence. Too often, models are precisely wrong.
Other tools are available to help you avoid this error. The price-to-earnings ratio (PER) is a regularly used proxy for stock valuation but also one of the most overused and abused metrics. To make use of it you need to know when to use it and when not to.
PER 101
The PER compares the current price of a stock with the prior year's (historical) or the current year's (forecast) earnings per share (EPS). Usually the prior year's EPS is used, but be sure to check first.
Last financial year, XYZ Ltd made $8 million in net profit (or earnings). The company has 1 million shares outstanding, so it achieved earnings per share (EPS) of $8.00 ($8 million profit divided by 1 million shares). In the current year, XYZ is expected to earn $10 million; a forecast EPS of $10.00.
At the current share price of $100, the stock is therefore trading on a historic PER of 12.5 ($100/$8). Using the forecast for current year's earnings, the forward or “forecast PER” is 10 ($100/$10).
It's often said that the PER is an estimate of the number of years it'll take investors to recoup their money. Unless all profits are paid out as dividends, something that rarely persists in real life, this is incorrect.
So ignore what you might read in simplistic articles and note this down: a PER is a reflection not of what you earn from a stock, but “what investors as a group are prepared to pay for the earnings of a company”.
All things being equal, the lower the PER, the better. But the list of caveats is long and vital to understand if you're to make full use of this metric.
Quality usually comes with a price to match. It costs more, for example, to buy handcrafted leather goods from France than it does a cheap substitute from China. Stocks are no different: high quality businesses generally, and rightfully, trade on higher PERs than poorer quality businesses.
Value investors love a bargain. Indeed, they're defined by this quality. But whilst a low PER for a quality business can indicate value, it doesn't alone guarantee it. Because PERs are only a shortcut for valuation, further research is mandatory.
Likewise, a high PER doesn't ensure that a stock is expensive. A company with strong future earnings growth may justify a high PER, and may even be a bargain. A stock with temporarily depressed profits, especially if caused by a one-off event, may justifiably trade at a high PER. But for a poor quality business with little prospects for growth, a high PER is likely to be undeserved.
Common trap
There's another trap: PERs are often calculated using reported profit, especially in newspapers or on financial websites. But one-off events often distort headline profit numbers and therefore the PER. Using underlying, or “normalised”, earnings in your PER calculation is likely to give a truer picture of a stock's value.
That begs the question; what is a normal level of earnings? That's the $64 million dollar question. If you don't know how to calculate these figures for the stocks in your portfolio, now is the time to establish whether it's skill or luck that's driving your returns. And if you don't know that, history may well make a monkey of you.
Greg Hoffman is research director of The Intelligent Investor.
http://www.brisbanetimes.com.au/business/dont-be-a-stockpicking-monkey-20110321-1c32p.html
Greg Hoffman
March 21, 2011 - 12:06PM
Monkeys are great stockpickers. Had your common-or-garden variety primate randomly selected five stocks in March 2009, chances are it would now be sitting on huge capital gains, contemplating reinvesting them in bananas - by the truckload.
It's easy enough for us to see that our monkey, who now sees himself as a future fund manager, is mistaking skill for luck. What's harder for us to see is how we might be making the same mistake ourselves.
If examining your portfolio's returns over the past few years engenders in you a feeling of self-satisfaction, you're running that risk. With the sharemarket falling recently now is the time to educate yourself. Consider what follows a lesson in fire safety.
Value investing is theoretically simple: buy assets for less than they're worth and sell when they approach or move beyond fair value. So too are valuing assets: discount future cash flows back to today at an appropriate interest rate for the life of the asset. The discounted cash flow (DCF) model is a commonly-used tool, hammered into every finance and business student.
But DCF models quickly deteriorate when they meet a rapidly changing world. The fact that most analysts failed to consider the impact of falling US house prices on their models played a major role in triggering the global financial crisis. Worse still, the misleading precision imbues investors with unwarranted overconfidence. Too often, models are precisely wrong.
Other tools are available to help you avoid this error. The price-to-earnings ratio (PER) is a regularly used proxy for stock valuation but also one of the most overused and abused metrics. To make use of it you need to know when to use it and when not to.
PER 101
The PER compares the current price of a stock with the prior year's (historical) or the current year's (forecast) earnings per share (EPS). Usually the prior year's EPS is used, but be sure to check first.
Last financial year, XYZ Ltd made $8 million in net profit (or earnings). The company has 1 million shares outstanding, so it achieved earnings per share (EPS) of $8.00 ($8 million profit divided by 1 million shares). In the current year, XYZ is expected to earn $10 million; a forecast EPS of $10.00.
At the current share price of $100, the stock is therefore trading on a historic PER of 12.5 ($100/$8). Using the forecast for current year's earnings, the forward or “forecast PER” is 10 ($100/$10).
It's often said that the PER is an estimate of the number of years it'll take investors to recoup their money. Unless all profits are paid out as dividends, something that rarely persists in real life, this is incorrect.
So ignore what you might read in simplistic articles and note this down: a PER is a reflection not of what you earn from a stock, but “what investors as a group are prepared to pay for the earnings of a company”.
All things being equal, the lower the PER, the better. But the list of caveats is long and vital to understand if you're to make full use of this metric.
Quality usually comes with a price to match. It costs more, for example, to buy handcrafted leather goods from France than it does a cheap substitute from China. Stocks are no different: high quality businesses generally, and rightfully, trade on higher PERs than poorer quality businesses.
Value investors love a bargain. Indeed, they're defined by this quality. But whilst a low PER for a quality business can indicate value, it doesn't alone guarantee it. Because PERs are only a shortcut for valuation, further research is mandatory.
Likewise, a high PER doesn't ensure that a stock is expensive. A company with strong future earnings growth may justify a high PER, and may even be a bargain. A stock with temporarily depressed profits, especially if caused by a one-off event, may justifiably trade at a high PER. But for a poor quality business with little prospects for growth, a high PER is likely to be undeserved.
Common trap
There's another trap: PERs are often calculated using reported profit, especially in newspapers or on financial websites. But one-off events often distort headline profit numbers and therefore the PER. Using underlying, or “normalised”, earnings in your PER calculation is likely to give a truer picture of a stock's value.
That begs the question; what is a normal level of earnings? That's the $64 million dollar question. If you don't know how to calculate these figures for the stocks in your portfolio, now is the time to establish whether it's skill or luck that's driving your returns. And if you don't know that, history may well make a monkey of you.
Greg Hoffman is research director of The Intelligent Investor.
http://www.brisbanetimes.com.au/business/dont-be-a-stockpicking-monkey-20110321-1c32p.html
Saturday, 6 November 2010
Evaluating a Stock
HOW-TO GUIDE HOME
INVESTING
Evaluating a Stock
Main points:
The most common measure of a stock is the price/earnings, or P/E ratio, which takes the share price and divides it by a company's annual net income.
Generally, stocks with P/Es higher than the broader market P/E are considered expensive, while lower-P/E stocks are considered not so expensive.
Don't automatically go for stocks with low P/Es simply because they are cheaper. Cheap stocks aren't always good stocks.
The following is adapted from “The Complete Money and Investing Guidebook” by Dave Kansas.
In assessing investments such as stock, investors consider the stock’s valuation, strategy, plans for diversification and appetite for risk. Stocks are evaluated in many ways, and most of the common measuring sticks are easily available online or in the print and online versions of The Wall Street Journal.
The most basic measure of a stock’s worth involves that company’s earnings. When you buy a stock, you’re acquiring a piece of the company, so profitability is an important consideration. Imagine buying a store. Before deciding how much to spend, you want to know how much money that store makes. If it makes a lot, you’ll have to pay more to acquire it. Now imagine dividing the store into a thousand ownership pieces. These pieces are similar to stock shares, in the sense that you are acquiring a piece of the business, rather than the whole thing.
The business can pay you for your ownership stake in several ways. It can give you a portion of the profits, which for shareholders comes in the form of a periodic dividend. It can continue to expand the business, reinvesting money earned to increase profitability and raise the overall value of the business. In such cases, a more valuable business makes each piece, or share, of the business more valuable. In such a scenario, the more valuable share merits a higher price, giving the share’s owner capital appreciation, also known as a rising stock price.
Not every company pays a dividend. In fact, many fast-growing companies prefer to reinvest their cash rather than pay a dividend. Large, steadier companies are more likely to pay a dividend than are their smaller, more volatile counterparts.
The most common measure for stocks is the price to earnings ratio, known as the P/E. This measure, available in stock tables, takes the share price and divides it by a company’s annual net income. So a stock trading for $20 and boasting annual net income of $2 a share would have a price/earnings ratio, or P/E, of 10. Market experts disagree about what constitutes a cheap or expensive stock. Historically, stocks have averaged a P/E in the mid teens, though in recent years, the market P/E has been higher, often nearer to 20. As a general rule of thumb, stocks with P/Es higher than the broader market P/E are considered expensive, while stocks with a below-market P/E are considered cheaper.
But P/Es aren’t a perfect measure. A company that is small and growing fast may have a very high P/E, because it may earns little but has a high stock price. If the company can maintain a strong growth rate and rapidly increase its earnings, a stock that looks expensive on a P/E basis can quickly seem like a bargain. Conversely, a company may have a low P/E because its stock has been slammed in anticipation of poor future earnings. Thus, what looks like a “cheap” stock may be cheap because most people have decided that it’s a bad investment. Such a temptingly low P/E related to a bad company is called a “value trap.”
Other popular measures include the dividend yield, price-to-book and, sometimes, price-to-sales. These are simple ratios that examine the stock price against the second figure, and these measures can also be easily found by studying stock tables.
Investors seeking better value seek out stocks paying higher yields than the overall market, but that’s just one consideration for an investor when deciding whether or not to purchase a stock.
Picking stocks is much like evaluating any business or company you might consider buying. After all, when you buy a stock, you’re essentially purchasing a stake in a business.
http://guides.wsj.com/personal-finance/investing/how-to-evaluate-a-stock/?mod=rss_WSJBlog/#mod=how_to_widget
INVESTING
Evaluating a Stock
Main points:
The most common measure of a stock is the price/earnings, or P/E ratio, which takes the share price and divides it by a company's annual net income.
Generally, stocks with P/Es higher than the broader market P/E are considered expensive, while lower-P/E stocks are considered not so expensive.
Don't automatically go for stocks with low P/Es simply because they are cheaper. Cheap stocks aren't always good stocks.
The following is adapted from “The Complete Money and Investing Guidebook” by Dave Kansas.
In assessing investments such as stock, investors consider the stock’s valuation, strategy, plans for diversification and appetite for risk. Stocks are evaluated in many ways, and most of the common measuring sticks are easily available online or in the print and online versions of The Wall Street Journal.
The most basic measure of a stock’s worth involves that company’s earnings. When you buy a stock, you’re acquiring a piece of the company, so profitability is an important consideration. Imagine buying a store. Before deciding how much to spend, you want to know how much money that store makes. If it makes a lot, you’ll have to pay more to acquire it. Now imagine dividing the store into a thousand ownership pieces. These pieces are similar to stock shares, in the sense that you are acquiring a piece of the business, rather than the whole thing.
The business can pay you for your ownership stake in several ways. It can give you a portion of the profits, which for shareholders comes in the form of a periodic dividend. It can continue to expand the business, reinvesting money earned to increase profitability and raise the overall value of the business. In such cases, a more valuable business makes each piece, or share, of the business more valuable. In such a scenario, the more valuable share merits a higher price, giving the share’s owner capital appreciation, also known as a rising stock price.
Not every company pays a dividend. In fact, many fast-growing companies prefer to reinvest their cash rather than pay a dividend. Large, steadier companies are more likely to pay a dividend than are their smaller, more volatile counterparts.
The most common measure for stocks is the price to earnings ratio, known as the P/E. This measure, available in stock tables, takes the share price and divides it by a company’s annual net income. So a stock trading for $20 and boasting annual net income of $2 a share would have a price/earnings ratio, or P/E, of 10. Market experts disagree about what constitutes a cheap or expensive stock. Historically, stocks have averaged a P/E in the mid teens, though in recent years, the market P/E has been higher, often nearer to 20. As a general rule of thumb, stocks with P/Es higher than the broader market P/E are considered expensive, while stocks with a below-market P/E are considered cheaper.
But P/Es aren’t a perfect measure. A company that is small and growing fast may have a very high P/E, because it may earns little but has a high stock price. If the company can maintain a strong growth rate and rapidly increase its earnings, a stock that looks expensive on a P/E basis can quickly seem like a bargain. Conversely, a company may have a low P/E because its stock has been slammed in anticipation of poor future earnings. Thus, what looks like a “cheap” stock may be cheap because most people have decided that it’s a bad investment. Such a temptingly low P/E related to a bad company is called a “value trap.”
Other popular measures include the dividend yield, price-to-book and, sometimes, price-to-sales. These are simple ratios that examine the stock price against the second figure, and these measures can also be easily found by studying stock tables.
Investors seeking better value seek out stocks paying higher yields than the overall market, but that’s just one consideration for an investor when deciding whether or not to purchase a stock.
Picking stocks is much like evaluating any business or company you might consider buying. After all, when you buy a stock, you’re essentially purchasing a stake in a business.
http://guides.wsj.com/personal-finance/investing/how-to-evaluate-a-stock/?mod=rss_WSJBlog/#mod=how_to_widget
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.
For readers who are unaware on how to calculate PE ratios, I have listed two usual ways below to calculate them.
The PE ratio is meaningless by itself. We have to examine it using the following two common techniques.
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.
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.
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.
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.
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.
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.
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.
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.
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
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
Monday, 6 July 2009
Earnings Yield: Bond versus Growth Stock
PE Ratio and Growth
It would be nice if looking at price, P/E, and earnings yield was all there is to it. Find an earnings yield of 6% (PE of 17), beat the bond, and move on.
But you're buying equities, not bonds, right?
Less risk.
----
But suppose the $5 earnings "coupon" grows at 10% per year. What happens at the end of year 10?
If the price were to stay the same, your $100 investment would be returning $12.97 in year 10, which is almost 13% earnings yield, or an implied PE of 7.7 at today's price.
A pretty nice yield, which really means the price of your investment should go up, because it's worth more.
This spreadsheet shows future earnings yields realized in the case of a bond with no growth versus a stock with a 10% earnings growth.
http://spreadsheets.google.com/ccc?key=0AuRRzs61sKqRcjdfd19OVTZrVVRlTUJnb05naGo3TWc&hl=en
So you can see that assessing growth is a major factor in analysing a stock price through PE.
Above all else, earnings growth drives stock price growth.
So value investors look closely at what the earnings yield is today and what will it be in the future.
It would be nice if looking at price, P/E, and earnings yield was all there is to it. Find an earnings yield of 6% (PE of 17), beat the bond, and move on.
But you're buying equities, not bonds, right?
- Because you want to participate in company growth and success.
- Because, simply, you want to leave that static bond yield in the dust - if not today, sometime in the near future.
- And you want to keep up with - or better yet, beat - inflation.
- So to do that, you assume some risk that earnings won't happen, but you are hanging your hat on growth and a stock price that keeps up with it.
- Buy a bond for $100; receive $5 per year for 10, 20, 30 years; never look back.
or
- Buy a stock for $100, earnings per share constant at $5 for 10, 20, or 30 years with no change.
Less risk.
----
But suppose the $5 earnings "coupon" grows at 10% per year. What happens at the end of year 10?
If the price were to stay the same, your $100 investment would be returning $12.97 in year 10, which is almost 13% earnings yield, or an implied PE of 7.7 at today's price.
A pretty nice yield, which really means the price of your investment should go up, because it's worth more.
This spreadsheet shows future earnings yields realized in the case of a bond with no growth versus a stock with a 10% earnings growth.
http://spreadsheets.google.com/ccc?key=0AuRRzs61sKqRcjdfd19OVTZrVVRlTUJnb05naGo3TWc&hl=en
So you can see that assessing growth is a major factor in analysing a stock price through PE.
Above all else, earnings growth drives stock price growth.
So value investors look closely at what the earnings yield is today and what will it be in the future.
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