Finweek English Edition - - INVESTMENT -

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.

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