How to use PEG

Company Simpson:

Recent PE 17.6 based on:

• a share price of $33 and
• TTM earnings of 1.87.

Earnings yields would thus be 1/17.6, or 5.7%.

What is the significance?

This investment could be compared to a long-term Treasury security as a prospective investment.

Treasury security: today yielding about 4.5%.

Which investment is better?

An investment in Simpson returns more, and, although riskier, it affords the opportunity for gain through growth.


The difference in earnings yield illustrates the basic risk/return tradeoff between investing in corporate equities versus safe fixed-income Treasuries.

----

You still don't know whether Simpson's PE ratio of 17.6 is attractive or compelling.

Long-time tech high-flyer Cisco Systems is at PE ratio to 27.4.

While banking stalwart Bank of America is at PE ratio of 10.


Why the difference?

The primary reason is growth.

Investors pay higher PEs for companies with greater growth prospects.

Greater prospects mean greater earnings and greater earnings yields sooner.

So when comparing businesses, one popular way to "normalize" PEs is to compare them to their respective company's growth rate.

From this comparison, you get a ratio known as PE to growth, or PEG:

Price/Earnings to growth (PEG) = (PE)/(EPSGR)

If the earnings growth rate of :

• Cisco is 25%, while
• Simpson's is 10% and
• Bank of America's is 5%,

then their respective PEG is:

• 27.4/25 or 1.1 for Cisco,
• 17.6/10 or 1.76 for Simpson, and
• 10/5 or 2 for Bank of America.

Now if you are confident in the sustainability of the growth rates, you'd pick Cisco as the best investment, because its PE is modest compared to its growth rate.

----

So, the lower the PEG, the better.

But if the low PEG is driven by high growth rates, you'd better be confident in the growth rate assumption.

Nothing falls faster than a growth stock that suddenly stops growing.

For years, Starbucks had been a high PE and high growth story, with PE ratios exceeding 30 and growth rates exceeding 20%. When the growth rate slowed just a bit in early 2007, the stock lost a third of its value.


----

Projecting growth rates can be tricky, and for that reason, value investors tend to shy away from stocks where growth appears temporary or hard to justify long term.

What rate should you use?
What the company has already achieved?
What the analysts project it to do?
Over what period?
When will the growth rate run into the law-of-large numbers-wall?
What growth rate did those Krispy Kreme Investors use in the 2000 - 2004 period?

Most of them ended up with a sticky mess.

The big question , of course, in picking Cisco as the "best investment," is the sustainability of the growth rate.

Simpson, while trailing a bit, may be a safer and better long-term investment.

Summary: It is okay to assume a high growth rate, so long as it is sustainable growth, based on sustainable business and marketplace fundamentals.

The Right Valuation Ratios

The market decouples price from the value of the business.

As Warren Buffett says, price is what you pay, and value is what you get. If the markets were perfect, price and value would go hand in hand, but as we all know, markets aren't perfect.

Once you appraise the business value, look at price and use valuation ratios to connect the price to the business.

PE: This is where most investors start, but it doesn't tell the whole story.
EY: Value investors look at present and future earnings yield (1/PE).
PEG: Price earnings to growth relates PE to growth rates and tells you something about that earnings yield future.
P/S, Profit Margin, P/B, and ROE: The relationships between price and these are also important.

For example:

FD interest rate = 3%.
PE of FD = 33.3.

So a PE of 25 or less is good given today's alternative earnings yields, but it doesn't mean that much without looking at the other numbers.

----

These valuation ratios are good signs (of value) for growing companies:

• a PEG of 2 or less,
• a P/S of 3 or less, and
• a P/B of 5 or less.

Lower figures of these valuation ratios can be expected for steady or transitioning companies.

----

Good Business, but Stock is too Expensive

Generalising is hard, but PE, PEG, P/S, and P/B well in excess of market or industry averages spell trouble in making the numbers, as does overdependence on abnormal margins.

These valuation ratios are signs of overcooked prices and raise questions of vulnerability and (un-)value:

PE: Look at PE compared to the market and the industry. A PE over 40 is hard to justify in any case. PE over 25 is hard to justify unless the growth story is there and intact.
EY: EY below 2.5%
PEG: PEG greater than 3
P/S: P/S greater than 3
P/B: greater than 10

Sam using PE

Samgoss said...
2 steed, i stated there nett asset,my nett asset is actually nett current asset which equal 2 current asset minus current liabilities.

What caused negative asset ? tak lain tak bukan is bcos of borrowing , come 2 NTA, NTA is nett tangible asset , tangible means something u can count n touch, what about goodwill ? all these depends on what type of biz they r involving.

WHen I said Low PE , u shouldnt just rely on its last year eps, u must look at its latest eps oso, that giving u a guide to know how she is doing now !?

That's y I always stressed there d importance of " past earning track records ".

Uncle sam using PE , do u know how 2 relate PE with others ? not just Low PE , from PE ..past , current n future eps + track records, all these r essential elements 4 u 2 forecast its future eps as well as PE.

as i said, it looks simple , u understand it doesnt mean u know how 2 apply it , it is just like financial crisis, some will take it as disaster but some may take it as opportunity , it depends on how well u understand on PE.

Yes, I am a PE man , but i can tell u, from PE , i can link lots of cause n effect into my PE.

One more thing , different industry has different PE , u cant compare PE of resorts with PE of Rcecap or Kfima , cos one is bluechip n d other one is penny stock. hence.. u must know what is d average PE 4 that industry !

Avg PE 4 banking is ard 15 to 20 , avg PE 4 penny stock is ard 12+- , hence when PBBor MBB dropped to PE ard 10+- , it is time to sailang , but u cant apply this to penny stock, cos it is not very cheap 4 penny stocks @ PE ard 10+_.

but one thing 4 sure , stock that traded with PE > 20 is no longer cheap !

D above is like telling u yr mom is a female , but i can assure that not many of them know how 2 apply it on shares invst, like what i always said , y d length of our fingers r not d same ^_-

July 3, 2009 7:26 PM


https://www.blogger.com/comment.g?blogID=2900671137131972978&postID=269801610029410286

How Value Investors View the Markets and Market Performance

Value investors really don't care. Do value investors have an attitude problem?

The point is that value investors aren't that concerned about markets, trading processes, and trading behaviour.

The market is simply a place to buy a portion of a business - and perhaps not sell it for a long, long time. Value investors care little about whether an order is executed on the bid or ask price, nor do they care what regional market, ECN, or execution system was used.

The transaction is an investment, a long-term investment. The market simply provides a place to acquire the investment.

So, value investors generally don't talk much about markets. And if you're really a value investor (or want to become one), you yourself don't care about markets... except when they undervalue businesses.

Despite the academic rumblings of the "efficient market theory" (which holds that with good information and a sufficient number of players, markets will find the right price for a business), markets are not perfect. They are always bargains.

Stocks may be undervalued because of:

• lack of knowledge or
• lack of visibility, or
• perhaps they're part of a group that's out of favour altogether.

These stocks are selling for less than may be indicated by the value of the business or the potential of the business.

So, in this sense, value investors love the markets. The markets, through their imperfections, provide value investors their opportunity.

As Warren Buffett says, if markets were perfect, he'd be "standing on the corner holding a tin cup."

Long-term Stock Market Growth and GDP

A stock market represents the sum total of the public's perception of the business value of the companies trading in that market.

True business value, is the sum total of productive assets and, in particular, what those assets produce in the form of current and future earnings.

As long as companies produce more, it makes sense that their values rise.

And as long as the public perception matches true value, the stock value rises in lockstep.

GDP

You can and should expect, in aggregate, that the total value of all businesses would rise roughly in line with the increase in the size of the economy, as represented by gross domestic product (GDP). This is true.

Business value grows further through increases in productivity.

The value of market traded businesses could rise still more if the businesses grew their share of the total economy - as Borders Group and Barnes and Noble have grown their share of the total bookselling business.

Long-term stock market growth (by most measures of return, 10-11% annually) can be explained by adding together the following:

GDP growth of 3 to 5%
Productivity growth of 1 to 2%
Long-term inflation in the 3 to 6% range

In the short-term, depending on the value of alternative investments, such as bonds, real estate, and so on, market value may actually rise faster or slower than business value. And inflation also tampers with market valuations.

So can markets grow at 20% per year?

Not for long. It isn't impossible for the markets to rise 20% in a given year or two, but such growth year after year is hard to fathom if the economy at large is growing at only 3 to 5% annually.

But for a particular stock?

Sure, it's possible. If the company is building a new busines or is taking market share from existing businesses, 20% growth can be quite realistic.

But forever?

Doubtful. Some call this "reversion to the mean" - sooner or later, gravitational forces will take hold and a company will cease to grow at above-average rates. As an investor, you must realistically appraise when this will happen.

Intrinsic Value = (2g+8.5) x EPS

Dissecting Graham's Intrinsic Value Formula


Graham's formula:
V = (2g+8.5) E x 4.4/Y

where,
V= intrinsic value
g= growth rate of earnings
E= current EPS
Y= current interest rate (average rate of high grade corporate bonds)

V = (2g+8.5) x (4.4/Y) x E

V = (Multiple) x E

Therefore the Multiple of E is a multiple of 2 components as illustrated

Multiple = (2g+8.5) x (4.4/Y)

(I) If Y is equal to 4.4
(4.4/Y) = 1
Multiple = (2g + 8.5)


(II) If Y is less than 4.4
(4.4/Y) > 1
Multiple > (2g + 8.5)


(III) If Y is greater than 4.4
(4.4/Y) < 1
Multiple < (2g + 8.5)


As we are presently in a low interest environment, let us assume that Y is equal or less than 4.4. Therefore, the multiple should be equal or more than (2g + 8.5), as in (I) and (II) above.

To be on the conservative side, we can use (2g + 8.5) as the multiple of EPS as a simple quick test to check on the stock's price and true value (intrinsic value).

Simplified Graham's formula:
V = (2g + 8.5) x EPS


EPS can be derived by multiplying [(1/PE) x Price of stock], both are readily available in the local paper.

Reminder: You shouldn't go out and buy or sell stock based on this formula alone, of course, but it's a great "quick" test of a stock's price and true value.

Graham's Intrinsic Value Formula

Graham did create a very useful and easy-to-use intrinsic value formula.

Graham's formula: You take a current earnings, apply a base P/E ratio, add a growth factor if there is a growth, and adjust according to current bond yield. The result is an intrinsic value that the stock can be expected to achieve in the real world if growth targets are met.

Formula: Intrinsic value = E x (2g + 8.5) x 4.4/Y

E = current annual earnings per share
g = annual earnings growth rate. (Graham would have suggested using a conservative number for growth.)
8.5 = base P/E ratio for a stock with no growth
Y = current interest rate, represented as the average rate on high-grade corporate bonds. (Note that lower bond rates make the intrinsic value higher, as future earnings streams are worth more in a lower interest rate environment.)

Take Hewlett Packard as an example. With current earnings (trailing 12 months) of $2.30 per share, a growth rate of 10%, and a corporate bond interest rate of 6%, the intrinsic value is

= $2.30 x [(2 x 10) + 8.5] x (4.4/6)
= $48.07 per share

This value almost exactly matches the price at the time that these calculations were made. That suggests little potential price appreciation in the stock - unless per share earnings growth accelerates or bond yields dip.

Acceleration in the business would increase the earnings growth rate, and share repurchases would increase the earnings per share. Both changes, especially taken together, would stimulate growth in intrinsic value.

You shouldn't go out and buy or sell stock based on this formula alone, of course, but it's a great "quick" test of a stock's price and true value.

Malaysian REITs

Malaysian REITs are:

• KPJ Reit
• Boustead Reit
• Amfirst Reit
• Axis Reit
• Hektar Reit
• Starhill Reit

and

• AHP
• AHP2,
• ARREIT,
• ATRIUM REIT
• QCAPITA REIT
• TWRREIT
• UOAREIT

Financial Year 2008
KPJ Reit
EPS: 7.4c
DPS: 7.7c
NAB/Share: 1.03
D/E Ratio: 0.53
Rental Income to Property Assets: 0.07
Nett Rental Margin: 94.52%
ROE 9.93%

DY range: 9.8% - 7.8%
Price range: 0.83 - 0.93
PE ratio range: 10.5 - 13.2

Financial Year 2008
Boustead Reit
EPS: 11.0
DPS: 10.9c
NAB/Share: 1.26
D/E Ratio: 0.14
Rental Income to Property Assets: 0.08
Nett Rental Margin: 97.77%
ROE 27.13%

DY range: 11.0% - 6.8%
Price range: 0.99 - 1.60
PE ratio range: 9.0 - 14.6

Financial Year 2008
AMFIRST Reit
EPS: 7.3c
DPS: 8.0c
NAB/Share: 1.03
D/E Ratio: 0.89
Rental Income to Property Assets: 0.07
Nett Rental Margin: 70.25%%
ROE 7.07%

DY range: 10.8% - 8.4%
Price range: 0.74 - 0.95
PE ratio range: 10.1 - 13

Financial Year 2008
AXIS Reit
EPS: 15.2c P
DPS: 14.9c
NAB/Share: 1.75
D/E Ratio: 0.07
Rental Income to Property Assets: 0.09
Nett Rental Margin: 84.41%
ROE 14.17%

DY range: 15% - 7.5%
Price range: 1.00 - 2.00
PE ratio range: 6.5 - 13.3

Financial Year 2008
HEXTAR Reit
EPS: 11.3c
DPS: 10.7c
NAB/Share: 1.26
D/E Ratio: 0.75
Rental Income to Property Assets: 0.12
Nett Rental Margin: 62.69%
ROE 15.01%

DY range: 14.7% - 7%
Price range: 0.73 - 1.54
PE ratio range: 6.4 - 13.4

Financial Year 2008
STARHILL Reit
EPS: 6.9c
DPS: 6.9c
NAB/Share: 0.97
D/E Ratio: 0.16
Rental Income to Property Assets: 0.08
Nett Rental Margin: 83.73%
ROE 7.09%

DY range: 9.8% - 7.5%
Price range: 0.70 - 0.93
PE ratio range: 10.2 - 13.4

Also read:
REITs - Selecting REITs

REITs - Selecting REITs

Choosing a good REIT is like choosing any other value investment.

Assets = Real Estate
Debt = Debt
Returns = Rents + other payments received on the portfolio.

An investor must analyze and compare a REIT's:

• management quality,
• real and anticipated returns,
• yields, growth,
• reserves, and
• asset values.

Many of the techniques for common stock can be put to work here.

PE and price to FFO (funds from operations) ratios are examined as they would be for other businesses.

• Compare the PE and price to FFO for the different REITs.
• Relate these PE and price to FFO to their growth rates.

Also important is the price to book, or P/B ratio.

• A REIT trading below its per-share book value is essentially trading at a discount.

Remember also that REITs are not immune to :

• asset quality problems,
• bad management and management decisions,
• declining markets, or
• poor expense management.

Do the due diligence.

Malaysian REITs are:

• KPJ Reit
• Boustead Reit
• Amfirst Reit
• Axis Reit
• Hektar Reit
• Starhill Reit

and

• AHP
• AHP2
• ARREIT
• ATRIUM REIT
• QCAPITA REIT
• TWRREIT
• UOAREIT

REITs - Property Portfolio

REIT investors should check out the property portfolio. This isn't easy, but it's easier than it used to be with online resources, usually provided by the REIT company itself.

Because real estate is not traded regularly, the ability to ascertain values is limited to:

• appraisals,
• replacement values, and,
• for income-producing properties, discounted cash flow analysis.

Appraisals are difficult to find.

Looking at the properties, and their locations, and assessing commonly reported local real estate price trends, occupancy rates, and economic trends, and whether the book value of a property is sustainable, is probably best.

If the REIT you choose is diversified with a number of different types of properties in different geographic regions, you will experience less volatility if an industry or locale experiences hard times.

If you are more concentrated, be sure that the type of property or the geographic area continues to be economically viable into the foreseeable future.

Occupancy rates for past and current years are available for most major and some smaller cities in the US from commercial real estate Web sites, and you may even wish to contact a local real estate professional.

REIT appraisal is difficult, but there is another way: REIT mutual and closed-ended funds, and there are even a few REIT ETFs. Many mutual fund families have funds built around REIT investments. REIT mutual funds are an easy way to get exposure to REITs without spending volumes of time researching the valuations of underlying holdings, vacancy rates, economic vibrancy, and so on. One way to find these funds is to enter "REIT mutual fund" in your search engine.

REITs - Debts and Leverage

Good REIT managers will typically hold debt levels to 35% or less of the total capitalization of the trust.

Some managers have long tenure and have weathered many storms.

The lower the level of debt, the more conservative management tends to be.

Also, look for managers investing their own funds in the REIT.

REITs - what and why

REITS are technically investment trusts that works like closed-ended funds holding real estate instead of stocks or bonds.

REITS pool investor money to allow average individual investors to invest in a portfolio of

• commercial,
• residential, or
• specialized real estate properties.

By buying shares in a REIT, you take proportional ownership in the real estate ventures that the trust owns. And these ventures range beyond traditional properties to health care and retirement facilities; ports and warehouses; even car dealerships, penitentiaries, and high-end hotels.

Certain REIT characteristics make them attractive to the value investor.

• Like closed-ended funds, REITS trade on the exchanges, often at a discount to NAV.
• It is possible to focus on certain types of real estate or certain regions of the country.
• And, typically, they pay healthy yields, often in excess of 5%, while providing some downside protection.

In the US, there are about 190 publicly traded REITs with some $400 billion of assets.

• REITs performed very well during the 2000-2002 market correction, and continued to perform well as real estate prices boomed in the middle of the decade, with a gain of 35% as a group in 2006.
• But as the real estate market soured in 2007, REITs and particularly those in the mortgage business or with highly leveraged portfolios, tended to suffer.

Investors like REITs for:

• their yield,
• their ownership with hard physical assets,
• their stability, and
• for their long-term performance, estimated at over 13% annually during 1975-2005, which is better than most stock investments.

Many investors pick REITs for their negative correlation with stocks - when stocks are doing poorly, REITs are doing well or are holding their own.

Value Investing: Provide a Margin of Safety

The idea of buying a company at a bargain price to achieve a margin of safety, provides a buffer if business events don't turn out exactly as predicted (and they won't).

The value investing style calls for building in margins of safety by buying at a reasonable price.

The style also suggests finding margins of safety within the business itself, for instance:

• so called "moats" or competitive advantages that differentiate the business from its competitors
• a large cash hoard, or,
• the absence of debt.

These offer a financial margin of safety.

Value Investing: Focus on Intangibles

Today's value investors are as intently focussed on business intangibles, like brand and customer loyalty, as on the "hard" financials.

It is all about looking at what's behind the numbers, and moreover, what will create tangible value in the future.

So a look at the market or markets in which the company operates is important.

Therefore, it is so important to look at:

• products,
• market position,
• brand,
• public perception,
• customers and customer perception,
• supply chain,
• leadership,
• opinions, and
• a host of others factor.

Value investing: It's not about diversification

Is diversification the key to investing success?

Diversification provides safety in numbers and avoids the eggs-in-one-basket syndrome, so it protects the value of a portfolio.

But the masters of value investing have shown that diversification only serves to dilute returns.

If you are doing the value investing thing right, you are picking the right companies at the right prices, so there's no need to provide this extra insurance.

In fact, over-diversification only serves to dilute returns.

That said, perhaps diversification isn't a bad idea until you prove yourself a good value investor.

The point is that, somewhat counter to the conservative image, diversification per se is not a value investing technique.

Value investing: No magic formulas

Some people look for a magic formula in investing that guarantees success.

Value investing isn't quite that simple.

There are so many elements and nuances that go into a company's business that you can't know them all, let alone figure out how to weigh them in your model.

So rather than a recipe for success, you will instead have a list of ingredients that should be in every dish. But the art of cooking it up into a suitable vlue invstment is up to you.

Like all othe investing approaches, value investing is both art and science. It is more scientific and methodical than some approaches, but it is by no means completely formulaic.

Value Investing: A Quest for Consistency

Value investors have varying approaches to risk, some willing to accept greater risk for greater rewards.

However, almost all value investors like a degree of consistency in

• returns,
• profitability,
• growth,
• asset value,
• management effectiveness,
• customer base,
• supply chain, and
• most other aspects of the business.

It's the same consistency you would strive for if you bought that espresso cart or hardware store yourself.

Before agreeing to buy that hardware store, you'd probably want to know that the customer base is stable and that income flows are steady or at least predictable. If that's not the case, you would need to have a certain amount of additional capital to absorb the variations. Perhaps, you would need more for more advertising or promotion to bolster the customer base.

In short, there would be an uncetainty in the business, which, from the owner's point of view, translates to risk.

• The presence of risk requires additional capital and causes greater doubt about the success of the investment for you or any other investors in the business.
• As a result, the potential return required to accept this risk, and make you, the investor, look the other way is greater.

The value investor looks for consistency in an attempt to minimise risk and provide a margin of safety for his or her investment.

This is not to say the value investor won't invest in a risky enterprise; it's just to say that the price paid for earnings potential must correctly reflect the risk.

Consistency need not be absolute, but predictable performance is important.

Value Investing: Always do due diligence

This cannot be repeated enough.

The value investor must do the numbers and work to understand the company's value.

Although there are information sources and services that do some of the number crunching, you are not relieved of the duty of looking at, interpreting, and understanding the results.

Diligent value investors review the facts and don't act until they're confident in their understanding of the company, its value, and the relation between value and price.

With great discipline, the value investor does the work, applies sound judgement, and patiently waits for the right price. That is what separates the masters like Buffett from the rest.

Investing is no more than the allocation of capital for use by an enterprise with the idea of achieving a suitable return. He who allocates capital best wins!

Value Investing is a style of investing

Value investing is a style of investing. It is an approach to investing.

As an investor, you will adopt some of the principles of this style of investing, but not all of them.

You will develop a style and system that works for you.

Since blogging, this journey has been an interesting and rewarding discovery.

A blended approach for the Value Investor

If you decide to take up the value investing approach, know that it doesn't have to be an all-or-nothing commitment.

The value investing approach should serve you well if you use it for, say 80% or 90% of your stock portfolio. Be diligent, select the stocks, and sock them away for the long term as a portfolio foundation.

But that shouldn't exclude the occasional possibility of trying to enhance portfolio returns by using more aggressive short-term tactics, like buying call options.

• These tactics work faster than traditional value investments, which may require years for the fruits to ripen.
• Of course, this doesn't mean taking unnecessary or silly risks, rather, it means that sometimes investments can perform well based on something other than long-term intrinsic value.
• It doesn't hurt to try to capitalize on that, so long as you understand the risks and are willing to face losses.
• In fact, it is best to think of a short-term trading opportunity as simply a very short-term value investment - a stock, for instance, is very temporarily on sale relative to its true value.

Likewise, it's perfectly okay to put capital away for short-term fixed returns. You don't have to work hard on "due diligence" for all parts of your portfolio at the same time.

• A solid base in bonds, money market funds, or similar investments (safe blue chips with sustainable dividend yield) will produce returns and allow you to focus your energy on the parts of your portfolio you do want to manage more actively.

You don't have to use the value investing approach for ALL your investments. Depending on your goals, it's okay to mix investing styles.

Throughout market history, much has been made of the different approaches to investing. There are:

• fundamental and technical analysis,
• momentum investing,
• trading,
• day trading,
• growth investing,
• income investing,
• speculating,
• story or concept investing
• theme play, and,
• academic treatment of security valuation and portfolio theory (institutional trading).

All styles make money some of the time, but no one style makes money all of the time. Each style suggests a different approach to markets, the valuation of companies, and the valuation of stocks.