The earnings multiple (p:e ratio) remains the most popular measure of value and while it should never be used in isolation, it certainly does tell us a lot about a stock, remembering that Buffett famously said: “Price is what you pay, value is what you get.” P:e is a quick and easy determination of value and when the p:e of a stock (or even a market as a whole) gets too high , most market commentators start to get nervous, but should they?
The f irst point is that different sectors and different stocks have different p:e levels. For example, the major banks tend to sit with a p:e of around 10 to 13 times, while the local retailers have historically been around 20 times. Individually, Richemont always has a high p:e while Naspers* has a p:e that hasn’t been under 30 since 2011, which hasn’t stopped the share price rocketing higher.
It’s important to compare the p:e against the stock’s peers but also against its longer-term p:e average and a value investor would want to be a buyer when the current p:e is below the longer-average p:e.
But what to do when one has a massively high p:e? First, try and determine what part of the ratio is driving it higher. Is the price moving higher or are earnings (HEPS) falling? If the latter, then one could potentially expect the stock to follow suit and fall and if the price has been rising, then you expect increasing earnings.
My simple rule of thumb is I like to see earnings growth higher than the p:e level. So if a stock is on a p:e of, say 20 times, I would look for HEPS growth to be + 20%; lower, and I consider growth to be disappointing. Simply put, this is the PEG ratio, which stands for priceto-earnings growth. Here you take the current p:e of a stock and divide it by the expected future one-year HEPS growth. So a stock on a p:e of 20 times but with expected HEPS growth of 30% is on a PEG ratio of 0.66. Anything below 1 is considered cheap, while above 1 is considered expensive and it is best used for growth stocks. The logic is simple: if the earnings are growing at a fast rate, you will be happy to pay a higher price as indicated by the p:e ratio.
In the case of Naspers, the current p:e is 43.6 times and consensus HEPS growth is 53.7%, giving a PEG ratio of 0.81 and suggesting the stock is not expensive. Of course the risk is in that expected growth number – it could be wrong and Naspers could come in with HEPS growth of only 35%, making the current valuation expensive.
The other issue with a high p:e is if a stock can grow into it. For example, Capitec** was on a p:e of 23 times two years ago and in the two years since, the price has only increased some 26% (fairly pedestrian for Capitec). But the earnings have increased well above this rate so the current p:e is 15.6 times and the earnings update of 32%-36% will put it on a p:e of around 10 times. So essentially the stock has grown into its p:e as earnings increase faster than the price. Shoprite** is another f lying stock that had a p:e of around 33 times at the beginning of the year, a massive number for the sector and the stock and even the current p:e of 27 times is expensive. With HEPS growth of only around 15% expected for the 2013 financial year makes it still expensive. So Shoprite would either have to fall further to offer value (ideally a p:e of around 20 times) or it could grow into the p:e. Growing into the p:e would mean the share price stagnates for a few years and if earnings increase say 35% over that period, the p:e would then be under 20 times and the stock would offer value again. Simon Brown is a Finweek contributor and heads justonelap.com, a free resource of f inancial information and investment education.
* Finweek is a Media24 publication, which is a subsidiary of Naspers.
* * The writer holds shares in Capitec and Shoprite.