Tuesday, 9 January 2018

Education Series - Financial Ratio: Re-Examine Your Understanding of PE Ratio

PE ratio is arguably the most commonly used financial metric in share investment. But many investors may not truly grasp the idea of PE and how can it be applied to shares investing.

In this article, I try to explain PE ratio using simple language, and highlight how it can be used in your daily investing decisions.

PE Ratio - The Concept
Imagine this. You have a sum on hand, and is prepared to acquire a food stall in the neighbourhood as an investment. As you approach the business owner, what would be your first question to ask?

Surely, one of the first few questions you would post is 'How is your business?'. That's in layman term. Essentially, you are asking 'How much does your food stall earn?'. The owner would probably reply 'Well, last year we earned $100k per year', or  'For the past 6 months, we on average raked in $10k net monthly.'

As a potential owner, you would want to know if business would be as good near future. 'What about coming year? Will business still remain as good?', you asked. 'Well looking at how we have done past 3 years, quite confident that this year's business would maintain or even increase!', so said the owner.

You would then take back this piece of info and assess it against the quoted purchase price, to determine if the food stall is a worthy purchase.

Now let's substitute the above 'food stall' with 'share', then we should understand PE intuitively: the price we are willing to pay to acquire full or partial stake in a business, assessed against its past earnings record and future expected earnings.

Layman Understanding of PE
With the understanding above, let's look at the mathematical formula of PE ratio:

Imagine again. Assuming the business landscape, products, and costs remain and the food stall's earnings stay the same next few years. In such a scenario, dividing the price you paid by the earnings, tells you how much time is required to recoup capital spent in acquiring the business.

That's right. PE ratio intuitively means the number of years needed to recoup your money spent if earnings stay constant (ignore whether the company's earnings flow into your pocket for now). If you had a good deal with PE 5, probably 5 years is enough to take back your capital. If you over pay for something that earns little, you may need 20 years (PE 20).

This is why usually a low PE stock is favoured over a high PE stock, because vis-a-vis its earnings, the low PE stock is deemed to be cheaper. You need less time to 'make back' your capital.

Assuming all else equal, naturally we would not want to over-pay. Paying too high a price increases the risk of not able to earn a decent returns and it takes much longer to recoup one's capital. Plus, what if business suffers in near future? Too much uncertainty.

PE Quoted is Based on Last Accounting Cycle
As per most money/finance concepts, PE is calculated based on earnings generated from the last full accounting cycle of one year - full year earnings (ie. 4 quarters).

There is a problem. Depending on where we are in the accounting cycle, and considering the inherent nature of business world that is highly dynamic, standard PE may not give the true picture of how cheap/expensive the share is.

For example, if we are currently in the 3rd quarter of the year, and business performance has worsen considerably in the last 3 quarters compared to last year. At PE 10 based on last year's Earnings per Share (EPS), a company would not be cheap as its business has deteriorated much lately. And based on more recent quarters' EPS, the more realistic PE would be 18.

Hence there is an 'updated' version of PE that is based on latest 4 quarters earnings, regardless of the accounting cycle, known as the Trailing Twelve Month (TTM)/trailing/rolling  PE, that paint a more accurate picture of business performance.

PE - Opinion Aggregating Past Earnings and Projected Growth
Recall the example in first section where you, as a buyer of a business, would ask about its past earnings and future expected earnings. The PE of a share also runs by the same concept - it is the market expressing a collective view on how much the company share price should be trading at, based on its past earnings, projected earnings, and industry outlook all blended together.

Hence it is only meaningful if we study a share's PE in comparison with other contexts, instead of viewing it in silo as a stand-alone determinant of share price.

PE in Comparison
In general a company's can be compared in 3 ways:
  • the company's historical PE
  • industry's average PE
  • broad market's PE
A company's PE over long period provide good understanding on its share price valuation range. This is because company earnings, over extended period, largely follow economic cycle. A time period that includes a complete cycle of industry downturn and boom time would provide a good indication of its top and bottom valuation range. And from here we would know whether share price is cheap or expensive historically.

We can also compare a company's PE against the industry's average PE. This stems from fact that an industry has its specific characteristics and dynamics, such that as a whole, companies within the sector should trade at roughly similar valuation. This also entails that it is only meaningful to compare a company's PE ratio against those in the same sector. We can't really place a property share alongside a technology share for comparison. Doesn't make much sense.

At a very broad level, the company can also be inspected against a diversified market's PE, usually the STI or industry index. This is more pertinent if the company is a constituent of a particular index. 

Let's look at an example: Singtel.

Singtel's PE and trailing PE compared to industry's and broad market's.
Extracted from Shareinvestor.com on 8 Jan 2018.

Singtel's PE ratio on 8 Jan, based on its full year earnings, is 15.3. However, its trailing PE is 10.3. This means that recent quarter's earnings have improved and it is valued more cheaply based on its trailing PE.

Against the Telecommunication industry, and the broad market of STI, or Large/Mid Cap Index, Singtel's PE appears to be in line. However, on trailing PE basis, Singtel is cheaper than STI and Large/Mid Cap Index.

PE Has to Be Used with Other Analysis and Indicators
PE is derived from past earnings using rear-view mirror, while investing involves a heavy dose of dealing with future that is essentially unknown and uncertain.

You can't use PE as the be-all-end-all yardstick to evaluate shares. Apart from necessary comparisons with PE in other contexts as shared above, one needs further homework on quantitative factors such as cash flow, debt level, revenue growth, and qualitative factors like industry analysis.

Risks of Investing in High PE Sector or Shares
When a company (or industry) trades at a much higher PE than its same-sector peers (or broad market), it usually means that the company/sector has shown good growth and promising prospects such that investors are willing to pay a higher price for its share.

However such optimism can sometimes gets out of hand when investors bid the share price up to an extremely rich PE level that is exorbitant and makes no sense, we can be sure that investment in these shares are quite speculative. For example, some technology stocks during the dot.com boom traded at PE of 250. Surely you would not buy a business that would return your capital in 250 years.

Ok let's leave the insane PE category aside and just talk about an expensive company with a still-plausible PE of 50 - Superb Tech Co. Investing in such a share will expose you to what I call a 'double whammy of earnings disappointment' that would have disastrous effect on the share price.

As seen from above, a single quarter of bad results could wreck the share price and cause a fall of almost 50% from $50 to $25.50. This is the potential impact of 'double whammy of earnings disappointment' - reduced earnings and PE downgrade.

Of course the above scenario is fictitious and exaggerated to illustrate my point. But for a more realistic example, refer to this post.

Low PE Sector or Shares are Less Risky
While high PE can be detrimental if the company growth does not match expectation, conversely, a low enough PE can do wonder to share price if its so bad that market does not harbour any hope of earnings growth on the company due to prolonged industry downturn or sustained bad results.

The concept and principles remain, just inversed: high PE to low PE, high expectation to low expectation, promising sector to boring sector. Scenarios such as:
  • cyclical industry on the cusp of multi-year recovery
  • company that has prolonged bad business and suddenly receives a huge order
Then your reward can be huge, in form of exponential jump in share price. 

Extremely Low PE Shares Have Their Pitfalls Too
Some industries are cyclical with clear boom and bust cycle. Examples of such industries include commodity, property, oil and gas. At the peak of market cycle, industry is expanding and companies enjoy high earnings. Correspondingly, PE would seem very low due to a large denominator.

But what follows could be an industry downturn where business activities shrink and earnings would drop. Share price would follow. So a very low PE in this case is deceptive because it indicates that market cycle is near its top. So an investor needs to be discerning enough to recognise such cycle, and avoid investing at cyclical top.

One example. Wilmar, the world's largest palm oil producer. Back in Jan 2017, its share price was around $3.80, with PE of around 15 based on Dec 16 full year results. Crude Palm Oil (CPO) price, according to BusinessInsider, was RM 3,250 back then.

However, due to the cyclical nature of commodity, CPO price has since been on a downward slide and dropped to around RM 2,300 Dec 2017. An investor attracted by its reasonable PE of 15 would see its share price drop from $3.80 to $3.20 now.

Top: CPO price chart Jan 17 to Jan 18. Bottom: Wilmar price chart Jan 17 to Jan 18.
Source: Businessinsider.com and Yahoo Finance

Another scenario of a deceptively low PE ratio could arise from really lousy companies that have no possibility of turnaround. Its earnings would continue to deteriorate and will turn into losses. When that happens, all is lost as there is no point investing in a loss making company.

How I Make Use of PE Ratio
Up till now, I have talked about the theory of PE. While they are not rocket science and the concepts are simple, understanding its relevance and appreciating its usefulness in real-life investment decisions still took me years.

PE is my first criteria in stock screener. Anything above 30 will be filtered out, for fear of the 'double whammy of earnings disappointment'.

As much as I try to form an informed opinion about company's prospect, industry outlook, the future is still, inherently, unpredictable. I acknowledge this fact, and take a balanced approach of not investing in high PE shares to reduce risks. Even if next earnings fall short, the not-extremely-high PE should cushion the fall to a certain extent.

Companies with borderline PE from 26 - 30, I will take a deeper look. They would need to have strong cashflow, low debts, comfortable dividend yield, and stable industry outlook, to compensate for my investment risks. And other usual due diligence applies: compare against historical figure, industry PE figure etc.

I also do not consider shares with extremely low PE such as below 5, for reasons illustrated earlier.

And I also calculate my portfolio's average PE - sum of each counter's PE apportioned by its portfolio weightage. This is then compared to that of market's and relevant sector indices, to gauge roughly how expensive or cheap my shares are.

I formulate these PE usage guidelines based on my investment experience, philosophy and belief. By nature, I am a more conservative investor so I would always ensure my downside is covered before pursuing higher returns. While this has prevented me from getting into high growth stock with exponential returns, it also shielded me from price plunge when earnings disappoint. I am willing to give up outsize returns for lower possibility of share price falling off the cliff.

You should form your own opinions about comfortable PE level for your investments, and regularly refine/enhance these rules to suit your investment style.

In this article, I have shared that
  • PE, conceptually, is akin to a scenario of paying certain amount to buy over small business
  • Relevance of viewing PE as number of years required to 'make back' your investment capital
  • Conventional PE is based on last year's earnings and trailing PE can be more useful
  • PE is relative and it must be examined against PE in various contexts
  • Risk of investing in high PE company due to 'double whammy of earnings disappointment'
  • Investing in low PE shares are in general, less risky, but not without its shortcomings too
  • How I use PE as a first line screening criteria and portfolio valuation metric
I opine that PE is a critical valuation tool and use it as a first line screener, because fundamentally, investing in shares is really about making an educated and informed deduction on reasonable share price, based on past earnings and future projected earnings. It combines both history and forward-looking expectations, hence it is important.

I hope you have a better understanding of PE now, and can better apply it in your investment decisions. 

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