Put valuation into perspective

N ovice investors often balk at the prospect of paying R1000 per share or US$100 per share for an equity holding, believing the company to be ‘too expensive’. More experienced investors, on the other hand, are hesitant to buy a company at a higher price to earnings ratio (PE ratio) compared to the market, arguing that the company must be ‘expensive’. In both cases, the thinking is flawed.

For novice investors, price substitutes for analysis and the price of a share is usually the only determinant of value. In other words, the higher the price, the more valuable or expensive the company. At the extreme, this leads to ‘penny stock investing’, based on the assumption that a low share price implies bargain territory.

A company’s share price is simply a function of its market capitalisation divided by its number of shares in issue. Two similar companies with similar market values, but with different amounts of issued shares, will yield very different share prices. If you are investing R1000 by buying 10 shares of R100 or one share of R1000, you are still getting R1000 of market value.

For more sophisticated investors, PE ratios or multiples tend to indicate whether a company is ‘expensive’ or a ‘bargain’. The thinking is that if two companies are similar in size and operate in the same industry, doing the same thing and making similar profits, then a company with a low PE ratio must be a ‘better’ investment than a company with a high PE ratio. But what these investors are failing to understand is that a PE ratio is not a reflection of the past, but rather a reflection of the future. In other words, the PE ratio is a reflection of the future profits the market expects the company to deliver going forward. Therefore, the higher the expected future growth rate of profits, the higher the price the market is willing to pay per unit of earnings and consequently, the higher the PE ratio.

As an example, let’s assume company XYZ and company ABC are similarly sized competitors in the same industry and generated the same profits last year. However, the market expects ABC to deliver twice the profits of XYZ in the next year.

Their respective PE ratios will depend on the outlook for profit growth over many years, using the simple example of one year’s expectation. Company ABC will therefore have a PE ratio of twice that of company XYZ. This is because in one year’s time, the higher PE ratio for company ABC would have ‘unwound’ to be the same as company XYZ and investors would have received the value implied by the higher PE ratio of company ABC. This value would be returned through higher dividend payments, assuming no share price growth and a 100% dividend pay-out ratio.

The point is that the share price you pay today is a reflection of expectations of the future, not of the past. A company trading at a higher PE ratio compared to its peers is expected to deliver higher profits than its peers in the future.

It therefore stands to reason that companies that consistently deliver revenue and earnings growth above their peers will consistently trade at higher PE multiples. Using the examples of company XYZ and company ABC, if ABC has a track record of achieving consistently higher growth and has the prospects to continue this into the future, then it will consistently trade at a higher PE compared to XYZ.

Many companies have demonstrated an ability to sustain earnings growth ahead of their peers and thus sustain a higher PE ratio over time. Nestle is one such example. The company is currently trading on a PE multiple of 26 compared to its average peer rating of 22. Ten years ago, the picture was pretty much the same and in our view, Nestle will continue to retain its higher PE rating relative to its peers for the next 10 years. This means those investors looking for a bargain based on low PE ratios would never invest in Nestle and would therefore not participate in the significant value this company creates for its shareholders.

While valuation is an important consideration in investing, it shouldn’t be the ‘be-all and end-all’ for determining whether to invest or not. Rather than obsessing about overpaying, investors should give due consideration to the quality and growth rates of a company in order to place its valuation into perspective.