This month: Mar­cus Padley

There is a mea­sure that gives in­vestors a more re­al­is­tic idea of a stock’s worth

Money Magazine Australia - - CONTENTS -

You all know what a PE ra­tio is: it is the price of a share di­vided by the earn­ings per share in a par­tic­u­lar year. So if a com­pany share price is $1 and it is earn­ing 10¢ per share this year, it is on a PE ra­tio of 10.

But there are a va­ri­ety of prob­lems with PE ra­tios and on its own a PE re­ally doesn't tell you very much. It ap­pears to al­low you to com­pare how cheap or ex­pen­sive com­pa­nies are rel­a­tive to each other but it has a ma­jor flaw. It doesn't take ac­count of earn­ings growth. It's no good, for in­stance, say­ing a com­pany that is on a PE ra­tio of 20 is ex­pen­sive and an­other on a PE ra­tio of 10 is cheap, if the com­pany on 20 is grow­ing earn­ings at 40% a year and the com­pany on 10 is see­ing no earn­ings growth at all.

Un­less the com­pa­nies you are com­par­ing are iden­ti­cal in ev­ery way, in­clud­ing earn­ings out­look, strength of bal­ance sheet, in­dus­try dynamics, risk and many more pos­si­ble in­vest­ment vari­ables, you re­ally can't com­pare them on PE ra­tio alone.

To make the point, there is a the­ory that if you take the 10 stocks with the high­est PE ra­tios at the be­gin­ning of the year they will al­ways out­per­form the 10 stocks with the low­est PE ra­tios over the next year. Here is a real-life ex­am­ple:

The high­est PE ra­tios in the top 100 in­dus­tri­als at the time of writ­ing in­clude CSL, Cochlear, Domino's Pizza, ResMed, REA Group, Trea­sury Wine Es­tates, Seek, Am­cor, Bram­bles, Aris­to­crat Leisure, Com­put­er­share and Ram­say Health Care.

Mean­while, the low­est PE ra­tios in the top 100 in­dus­tri­als in­clude Har­vey Nor­man, TPG Telecom, Bank of Queens­land, Na­tional Aus­tralia Bank, Com­mon­wealth Bank, West­pac Bank, Lendlease, Bendigo and Ade­laide Bank, Tel­stra and AMP.

If it's growth you're af­ter, I think I know which port­fo­lio you should be hold­ing. But the PE ra­tio doesn't tell you that; in­stead, if

you use the PE as a fil­ter on its own, it sim­ply di­rects you to the low-growth, bor­ing stocks. On the flip­side, high PE ra­tios are the mar­ket iden­ti­fy­ing growth for you.

And there are other is­sues with PE ra­tios, most no­tably that earn­ings per share num­bers are a func­tion of ac­count­ing stan­dards and tech­niques. If, for in­stance, as hap­pened in the 1980s, man­age­ment was paid a bonus de­pend­ing on the de­clared earn­ings per share num­ber, it could (and still can) do all sorts of things to ma­nip­u­late a higher pub­lished earn­ings num­ber. There was a very good book about it 20 years ago called Ac­count­ing for Growth – Strip­ping the Cam

ou­flage from Com­pany Ac­counts by my old boss in Lon­don, Terry Smith, all about cre­ative ac­count­ing by listed com­pa­nies.

An­other is­sue is that some com­pa­nies, such as a lot of in­fra­struc­ture stocks, can't be as­sessed on pub­lished earn­ings be­cause, hav­ing spent bil­lions of dol­lars up­front build­ing as­sets, they then spend the next few decades min­imis­ing their statu­tory earn­ings and tax by us­ing their huge de­pre­ci­a­tion and amor­ti­sa­tion pro­vi­sions to bring their earn­ings as close to zero as pos­si­ble. This is why a lot of in­fra­struc­ture com­pa­nies don't rate on any “value”-based anal­y­sis or in­trin­sic-value anal­y­sis.

An­other is­sue with the PE ra­tio is that it only re­lates price to earn­ings, not to risk. You could have two com­pa­nies on the same PE ra­tio but one could have cash on the bal­ance sheet and the other 200% gear­ing. The PE ra­tio tells you noth­ing about the bal­ance sheet or risk.

So we need some­thing bet­ter, and that comes in the form of what is called the PEG ra­tio, or PE ra­tio-toearn­ings growth ra­tio.

The PEG ra­tio re­lates the PE of a com­pany to the growth in earn­ings. In the eyes of some fund man­agers, mostly ac­tive growth-ori­en­tated fund man­agers, when it comes to fil­ter­ing stocks on ra­tios, this is the best fil­ter in the busi­ness.

To cal­cu­late the PEG ra­tio you sim­ply di­vide the PE ra­tio by the earn­ings per share growth rate for any par­tic­u­lar share. So if a com­pany is on a PE of 10 and is grow­ing earn­ings at 10%, the PEG ra­tio is 1. Now we can com­pare com­pa­nies tak­ing growth into ac­count.

It fol­lows from the maths that the lower the PEG ra­tio the bet­ter. So what is a good PEG ra­tio? Gen­er­ally, a PEG ra­tio of over 2 sug­gests a stock is ex­pen­sive and a PEG ra­tio be­low 1 puts it on the radar. And if a PEG ra­tio of 1 is fair value, which is cus­tom­ary think­ing, then a PEG ra­tio above 1 sug­gests that the share price is over­es­ti­mat­ing the growth in earn­ings. On that ba­sis the stock is over­priced. And vice versa: a PEG ra­tio un­der 1 sug­gests that the mar­ket is not pric­ing in the growth in earn­ings.

To prove the point, some of the high­est large com­pany PEG ra­tios in Aus­tralia in­clude Wes­farm­ers, Har­vey Nor­man, NAB, CBA, West­pac and ANZ. Now maybe you un­der­stand why the bank sec­tor is strug­gling to re­cover. It's all about growth, and to spot that the PE is use­less and the PEG ra­tio is bet­ter.

Mar­cus Padley is a di­rec­tor of MTIS Pty Ltd and the au­thor of the daily stock­mar­ket news­let­ter Mar­cus To­day. For a free trial of the news­let­ter go to mar­cus­to­day.com.au.

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