This month: Marcus Padley

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

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.