Don’t fear stocks with high P/Es
One of the most common comments about investing is that one should never buy a stock with a high priceto-earnings ratio (P/E). The view is that a stock with a high P/E is very vulnerable to a price collapse, thus reducing its P/E and therefore offering value. But this isn’t always the case. What one should rather do is examine the high P/E closely to understand not only why it is high but also how it could unravel.
For e x a mple, i f you’ d bought Aspen when it had a P/ E of over 80 times back in 1999, you would have been paying less than R10 for a stock that is now worth over R360. Its P/ E today is around 32 times. Now, sure, a P/ E of 32 times is not cheap on the surface, but a P/ E of over 80 times was expensive by any measure, yet if you’d shied away because of the high P/E you’d have missed one of the best performers the JSE has seen over the past decade and a half.
So how should we view a high P/E? Well, f irstly, understand what makes up a P/ E ratio. There are t wo parts: price and earnings (headline earnings per share or HEPS), so a change in either inf luences the P/E. A high P/E will move lower i f either the price drops or the earnings increase.
So i f a P/ E is high, what is t he ea r nings growth potentia l going forward? Now you are looking at the So here’s how I look at high P/E stocks. The first question I usually ask is what sort of HEPS growth we can expect over the next five years? Let’s say we have a stock that we think can average 50% HEPS growth for five years (and I stress that level of growth is not sustainable forever, so I assume that it will only continue for another five years and keep in mind that growth may be organic if acquisitions occur).
PEG ratio. The PEG ratio is P/ E divided by expected percentage oneyear growth in HEPS.
So a stock on a P/E of 40 times and expected HEPS growth of 50% has a PEG ratio of 0.8. A PEG below 1 is considered attractive, but a value above 1 is considered expensive. This formula is nice and neat but still needs further unpacking.
If we are predicting the potential HEPS growth, we have to accept the risks involved in that prediction. But this is looking at just one year’s growth and as an i nvestor we are generally looking much further than just one year. If current HEPS = and a stock grows by a year for five consecutive years, its HEPS will be almost 760c in the fifth year.
So let’s assume the share is worth We will also assume that the share price doesn’t move in five years. We convert the share price into cents and divide it by the HEPS. This is the P/E.
Then I come up with a reasonable P/E for that stock in year five relative to its peers and expected growth from then onwards. Say we agree that a P/E of 20 times is fair in year five.
Then we divide the 20 times by the 6.57 times (from the above calculation). The calculation would look like this: This shows that the share price can triple. If the HEPS growth happens as expected, the stock would be on a P/E of 20 times.
So we have a tripling of the share price and a reduction in the P/E ratio all because earnings grew at a rapid enough rate to unwind the expensive P/E.
So don’t be put off by expensive P/E levels, rather run the sums and see if that P/E can unwind itself. The problem of course is that trying to predict future earnings five years out is very risky.