How to determine if a stock with a high P/E is offering value
So is that share with the high price-to-earnings ratio actually going to be worth all the money you shell out? Simon Brown discusses another benchmark that would help to measure a stock’s price.
iwrote last week about finding the next Capitec*. But when we do, we run into another challenge – the stock will likely be very expensive by pretty much every valuation metric, especially the price-toearnings ratio (P/E).
We can, however use the P/E growth (PEG) ratio to check if a fast-growing, high P/E stock is offering value. PEG takes the current P/E and uses next year’s earnings (headline earnings per share, or HEPS) percentage growth, giving a different but important slant on a P/E, be it forward or historic.
The issue is where do we get next year’s earnings and hence earnings growth? We can use the consensus forecasts that many brokers offer – here various stock analysts are polled and asked to give their expected future earnings for a stock. The average or consensus view is then published.
There are two potential problems here. First, there may be no consensus forecasts for smaller stocks, which would leave us in the dark. Second, the analysts making forecasts may well be wrong. If we’re going to use consensus forecasts, we must accept the potential for being wrong.
Another way to get earnings growth is through trading updates. This is late in the process but better than nothing.
The link between P/E and PEG
If the stock is not being covered by analysts, you can work out your own earnings growth.
Start by looking at the recent trend – are earnings increasing or decreasing? What was the outlook from the previous set of results? This will give you a starting point and a rough idea of what the growth will be.
So, with your rough expected growth in earnings, what the PEG does is divide the historic P/E into the growth. A number below 1 indicates value in a high-growth stock while a figure higher than 1 indicates an expensive highgrowth stock.
Put more simply: is the earnings growth expected to be higher than the current P/E? A P/E of 50 times is fine if expected growth is 75%, as that’s a PEG of 0.66.
Using an example
Digging deeper, let’s look at private education group Curro*, which is trading at a P/E of over 130 times. The latest trading statement says growth in earnings will be between 52% and 67%. This is great growth, but with that P/E the stock remains expensive on a PEG of just over 2 (P/E of 130 divided by growth of 60%).
But as we know, Curro is very much in rampup mode as it opens and fills new schools and, of course, spends money. Occupancy levels are not yet optimal so as spending slows (as new builds slow down), income will grow and the company’s base costs (e.g. teacher salaries) will be largely static. This will boost growth and the stock will “grow” into its high P/E. That said, I think Curro is very expensive at around 5 000c, even with all the future potential, and here’s my maths: First, let’s assume HEPS growth of 60%, making for 46c HEPS for the full year to end February. At the current 5 000c, that makes a P/E of just over 100 times, and with HEPS growth of 60% it remains expensive. But at 4 000c, using the same HEPS, we get a P/E of 87 times, while at 3 000c the P/E is 65 times and in line with growth. Using the above assumptions, you’d want to buy Curro on price weakness. This may not happen, but at 5 000c your margin of safety is nothing. Any slip by the company and the price will be under severe pressure. However, at 3 000c you’d be able to buy at a much better valuation (the stock was at 3 500c in mid-2016).
This is far from an exact science but you can see how to pull apart numbers, look into the future and get an idea if earnings growth justifies the high valuations on a stock.
A number below 1 indicates value in a high-growth stock while a figure higher than 1 indicates an expensive highgrowth stock.