Don’t fear stocks with high P/Es

Finweek English Edition - - INVEST DIY - 100c 50% R50 with a P/E of 50 times. 5 000 ÷ 760 = 6.57. 20 ÷ 6.57 = 3.

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).

EX­AM­PLE:

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.

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