Price-Earning Ratio 101

What actually is PER?

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.

PER:  Historical versus Forward or Forecast PER

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.

For example:

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).

Quality has a price to match

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.





Low PER doesn't alone guarantee quality business

• 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.
• 
  

High PER with strong future earnings growth maybe a bargain

• 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.

Avoid a Common trap: Use underlying or normalised earnings in PER


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.





What is a normalised level of earnings?

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.




An old encounter with low PE stock: Hai-O


It is nostalgic to re-read an old post on Hai-O by ze Moola. 

http://whereiszemoola.blogspot.com/2008/04/more-on-haio.html

Sunday, April 13, 2008
MORE ON HAIO

My dearest BullBear,

A low PE stock means only one thing and that is the stock is trading on a lower valuation compared to what it is currently earning.

Some simply consider that what is happening is the stock is being ignored in the market despite its impressive earnings.

Why?

The market could be wrong and that perhaps this is a stock that's an ignored gem. Yeah, the classical hidden gem and if this is the case, investors who invests in the stock could be rewarded for their stock selection.

However, on the other hand, sometimes the market could be right and that they do sense something is not right within the stock.

And because of this reasoning, I have always realised that a low PE stock does not make a stock a QUALITY stock.

It just means the stock is trading 'cheaply'.

It could be a bargain but it could also be a trap.

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

Buffett at University of Kansas (2005): You can still earn extraordinary returns on smaller amounts of capital.

University of Kansas : Warren Buffett Q&A
Notes by Professor Hirschey, University of Kansas ( May 6, 2005 )

Question: According to a business week report published in 1999, you were quoted as saying “it's a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” First, would you say the same thing today? Second, since that statement infers that you would invest in smaller companies, other than investing in small-caps, what else would you do differently?

Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today's environment because information is easier to access.

You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map - way off the map. You may find local companies that have nothing wrong with them at all. 

A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!! I tried to buy up as much of it as possible. No one will tell you about these businesses. You have to find them.

Other examples: Genesee Valley Gas, public utility trading at a P/E of 2, GEICO, Union Street Railway of New Bedford selling at $30 when $100/share is sitting in cash, high yield position in 2002. No one will tell you about these ideas, you have to find them.

The answer is still yes today that you can still earn extraordinary returns on smaller amounts of capital. For example, I wouldn't have had to buy issue after issue of different high yield bonds. Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.

I know more about business and investing today, but my returns have continued to decline since the 50's. Money gets to be an anchor on performance. At Berkshire's size, there would be no more than 200 common stocks in the world that we could invest in if we were running a mutual fund or some other kind of investment business.


http://www.valueplays.net/wp-content/uploads/vinvesting-com.pdf

Nine reasons Warren Buffett loves Lubrizol (QVM approach)

MARCH 18, 2011, 10:25 A.M. ET

Why Warren Buffett Just Spent $10 Billion

By BRETT ARENDS

In other news on the markets this week, Warren Buffett quietly made an acquisition.

A big one. Even by his standards.

The 80-year old investor put down $9.7 billion, or about a quarter of Berkshire Hathaway's entire cash pile, to buy Lubrizol Corporation, a specialty chemicals company based in Wickliffe, Ohio.

What does this mean for you? Warren Buffett's investment moves are usually worth a closer look, even if you're not one of his stockholders. After all, he's one of the most successful stock pickers ever. And it's never too late to practice your swing, even if your own stock portfolio is closer to $20,000 than, say, $20 billion.

A look through the company's financials reveals nine reasons Warren Buffett loves Lubrizol.


QUALITY (Q) 

1. It has a lucrative niche.

Lubrizol's main business is making additives for fuel, which make engines run better and last longer. They are a small part of the cost of the fuel, but they are valuable to the end users and they are lucrative. Lubrizol's gross margins last year were a thumping 33%, up from 25% five years ago. The company's return on equity is 34%.

2. It has a wide moat.

Lubrizol has little trouble defending its business from competition. It has been around for 82 years – even longer than Mr. Buffett – and has built up a strong franchise. It is the market leader in the industry. And the fuel additives industry is technically advanced. Lubrizol owns a remarkable 1,600 patents and has 6,900 employees worldwide.

3. It's in a dull industry.

Nobody goes into the fuel additives business for the glamour. Venture capitalists are not throwing money after new fuel additives start-ups. Companies in the sector do not typically give away their products for free to gain market share, "eyeballs," "mind share" or the like. Indeed some of the existing players have been getting out – making life better for those who are left.

4. It has pricing power.

Mr. Buffett recently said "the single most important decision in evaluating a business is pricing power. If you've got the power to raise prices without losing business to a competitor, you've got a very good business." At a time of rising raw material costs, that's especially important. Lubrizol fits the bill. The company's own raw materials jumped 10% last year, but it was able to pass those costs on to its customers.

5. It's stable.

Sales fell 9% in 2009, but gross profits actually rose, from $1.1 billion to $1.5 billion. And the company says less than half of its revenues rely on boom-and-bust cyclical industries, such as construction and industrial production. Lubrizol had $2.7 billion in total liabilities at the end of last year – and $2.5 billion in cash and other current assets. Dividends have risen steadily, from $1.04 per share five years ago to $1.39 last year.

6. It benefits from overseas growth.

Two-thirds of last year's revenues came from outside the U.S.A. The company has 40% of its plant and equipment overseas. And that's rising. Last fall Lubrizol broke ground on a new factory in southern China, that will begin production in 2013. The company is a big beneficiary from economic growth in emerging markets. In countries like China, India and Brazil, hundreds of millions of people are moving into the middle class, buying cars, and driving them more. Every drive needs fuel, and every gallon of gas needs additives.

7. It has low unionization.

Just 4% of Lubrizol's U.S. employees are members of a union (although some overseas workers are also members of collective bargaining agreements). That's good for profits. Mr. Buffett may be a Democrat at nights and on weekends, but when he's at the office he's all business.


VALUATION (V)

8. The stock was reasonably priced.

Even a great company can be a bad investment if you pay too much for it. In the case of Lubrizol, Mr. Buffett is paying $135 a share. That's less than 13 times last year's earnings, and 12 times forecasts for 2011. If you find a good company at a good price, who cares what "the market" is doing?

MANAGEMENT (M)


9. He likes the management.

Lubrizol chief executive James Hambrick has been with the company since 1973, when he started there as a co-operative education student. He's been CEO for seven years. "Lubrizol is exactly the sort of company with which we love to partner – the global leader in several market applications run by a talented CEO, James Hambrick," Mr. Buffett said when he announced the deal. "Our only instruction to James – just keep doing for us what you have done so successfully for your shareholders."

http://online.wsj.com/article/SB10001424052748703328404576207040639038696.html

If you find a good company at a good price, who cares what "the market" is doing?"

When buying a great wonderful company, also ensure that the stock was reasonably priced.

Even a great company can be a bad investment if you pay too much for it. 

In the case of Lubrizol, Mr. Buffett is paying $135 a share. That's less than 13 times last year's earnings, and 12 times forecasts for 2011. 

If you find a good company at a good price, who cares what "the market" is doing?

Do you live in a meritocracy?

Judge a person on his merits, rather than on your personal feelings.

What is merit?   This is basing your opinion on what is worthwhile about a person or thing.

The decision on whether to retain or replace a person should be based on one criteria – merit.

Do you live in a meritocracy?  Are you ruled by such people of  high ability?

'Nepotism' - Murdoch sued for buying daughter's business

March 17, 2011 - 11:38AM

The board of News Corp has been sued by shareholders for agreeing to buy a business owned by chairman Rupert Murdoch's daughter for about $US675 million.

A trustee for several retirement funds said the board of News Corp approved the "unfairly" priced deal without questioning or challenging the elder Murdoch, who founded the company and is also chief executive.

News Corp spokeswoman Teri Everett described the suit as "meritless".

The chairman of News Corp said he expected his daughter Elisabeth to join his company's board after buying her Shine Group television production business.

The acquisition still needs approval by News Corp's audit committee and the approval of each companies' respective boards. It also requires an independent fairness opinion.

The deal raised new questions about succession at News Corp, which owns the broadcaster Fox and publishes the Wall Street Journal.

"In short, Murdoch is causing News Corp to pay $US675 million for nepotism," said the lawsuit, which was filed overnight in Delaware's Chancery Court.

"In addition to larding the executive ranks of the company with his offspring, Murdoch constantly engages in transactions designed to benefit family members," said the lawsuit by Amalgamated Bank, a trustee for several investment funds holding more than 1 million News Corp shares.

The lawsuit also was joined by the Central Laborers Pension Fund.

The lawsuit seeks damages and a declaration the board breached their fiduciary duty to shareholders.

The case is Amalgamated Bank et al v K. Rupert Murdoch et al, Delaware Chancery Court, No. 6285.

Reuters

Parkson Holdings to expand into Indonesia retail market

Parkson Holdings to expand into Indonesia retail market
Written by Joseph Chin of theedgemalaysia.com
Thursday, 17 March 2011 19:23


KUALA LUMPUR: PARKSON HOLDINGS BHD [] is teaming up with PT Tozy Bintang Sentosa (TBS) to expand its Parkson department stores in Indonesia.

Parkson said on Thursday, March 17 it signed an exclusivity agreement with TBS Group for the proposed collaboration.

The TBS Group operates six retail stores under the brand names of Centro Lifestyle Department Store and Kem Chicks in Indonesia and it planned to add another two more stores.

The eight stores were expected to generate more than US$100 million in sales turnover in 2011.

“The proposed collaboration provides Parkson with an opportunity to establish a presence in Indonesia and extend its international network into Indonesia which has a large domestic retail market given its population base of over 240 million people,” it said.

Parkson operates 89 department stores in Malaysia, China and Vietnam.

`Worst Case' Nuclear Disaster Hangs on Unlikely Events. There is a 10% probability still.

For Tokyo Electric Power Co.’s stricken nuclear reactors to release catastrophic amounts of radioactive material into the atmosphere, a rare chain of events needs to happen.

Averting a full-scale meltdown -- which scientists say isn’t likely -- depends on cooling the uranium-containing rods at Fukushima Dai-Ichi’s Reactor No. 2, said S.K. Malhotra, a scientist at India’s Department of Atomic Energy in Mumbai. A worst-case outcome may occur if overheating in the reactor culminates in the rupture of the steel lining protecting radioactive material.

“In the worst scenario, an explosion could occur inside the steel pressure vessel, fuel bundles melt down and the radioactivity is exposed,” Malhotra said in a phone interview. “I would say there is a 10 percent probability still.”

Read more here:

http://www.bloomberg.com/news/2011-03-15/-worst-case-nuclear-disaster-in-japan-hangs-on-string-of-unlikely-events.html

Dangers for Human Health From Radiation Poisoning: Questions and Answers
http://www.bloomberg.com/news/2011-03-14/understanding-risk-of-radiation-poisoning-in-japan-questions-and-answers.html

`Panic Selling' Doesn't Pay. Who is a panic seller?

Definition of Panic Seller.  This is an investor who: 

1.  sells on a day when the benchmark falls 2.5% or more,

2.  stays away from stocks for at least 20 trading days, and

3.  returns only after the initial loss has been recouped.

(Source:  Bank of America Merrill Lynch) 

`Panic Selling' Doesn't Pay in U.S. Stock Market: Chart of the Day

By David Wilson - Mar 15, 2011 10:27 PM GMT+0800l

U.S. stock investors who avoid “panic selling” are likely to be rewarded for their patience, according to a study by Bank of America Merrill Lynch.

This conclusion is based on a comparison of the Standard & Poor’s 500 Index with an adjusted version, calculated by the firm. The latter assumes an investor sells on a day when the benchmark falls 2.5 percent or more, stays away from stocks for at least 20 trading days, and returns only after the initial loss has been recouped.

The CHART OF THE DAY compares the S&P 500 with index readings derived from Merrill’s data, which goes back to 1960. The adjusted benchmark would have finished last year at 459.46, about 63 percent lower than its actual close.

“As tempting as it can be to exit the market after a sell- off in an attempt to buy back at a lower price, timing re-entry is very difficult,” David Bianco, chief U.S. equity strategist at the firm, wrote yesterday in a report. “The market’s best days tend to come very close to the worst days.”

Staying invested is a more rewarding strategy as long as the earnings outlook is intact and stocks aren’t too expensive, Bianco wrote. He sees profits climbing 11 percent this year at S&P 500 companies and expects the index to finish the year at 1,400, a gain of 8 percent from yesterday’s close.

There have been 29 years since 1960 in which the S&P 500 had at least one daily decline of 2.5 percent or more, according to Merrill. The panic-selling strategy did better than the index in only six of them, most recently in 2008.

http://www.bloomberg.com/news/2011-03-15/-panic-selling-doesn-t-pay-in-u-s-stock-market-chart-of-the-day.html

This article below is to remind us what happened in 2008.

Investors Survive Selloff But Worry What's Next

Published: Monday, 15 Sep 2008 | 4:51 PM

Investors survived the first trading day of the Wall Street financial crisis, but many remained worried about what happens next.

A day after investment bank Lehman Brothers filed for bankruptcy and Merrill Lynch was forced to sell itself to Bank of America, the focus of many investors turned to giant insurer American International Group [AIG 36.78 -0.72 (-1.92%) ], which is struggling for survival.

The market is worried about a possible failure of AIG as early as Tuesday morning, said Matt Cheslock, a senior specialist at Cohen Specialists, and traders just don't want to stick their necks out amid that kind of uncertainty.

"If AIG fails tomorrow morning, it's the same thing written all over this market," Cheslock said. "I don't think anyone is going to want to take any positions overnight."

US stocks closed sharply lower as worries about AIG—on top of the crises at Lehman and Merrill—sparked a 500-point drop in the Dow. Markets in Asia and Europe also sold off, though Tokyo and several other Asian money centers were closed for holidays.

The dollar sank against the yen and the euro.

Oil prices, responding to the turmoil in financial markets more than Hurricane Ike, plunged to $92 a barrel.

The Federal Reserve refused to provide temporary financing for AIG, which has incurred $18 billion in losses over the past three quarters from soured mortgages. But the government has asked Goldman Sachs [GS 157.25 -1.18 (-0.74%) ] and JP Morgan Chase [JPM 44.61 -0.69 (-1.52%) ] to lead a group of banks to offer up to $75 billion in credit for the troubled insurer.

But AIG's survival remains uncertain, and investors are worried that there are other companies that may need to raise capital to cover mortgage-related losses.

Treasury Secretary Henry Paulson said on Monday the U.S. financial system remained sound despite current stresses and he was prepared to take further actions if necessary to maintain stability.

"So far, the efforts of the US government have failed to bring any stability to the financial markets,'' said Kathy Lien, director of currency research at Global Forex Trading.

http://www.cnbc.com/id/26718389/Investors_Survive_Selloff_But_Worry_What_s_Next