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.

Finweek English Edition - - MARKET PLACE - Ed­i­to­rial@fin­week.co.za

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.

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