You all know what a P/E ratio is, it is the price of a share divided by the earnings per share in a particular year. So you as an investor pay one dollar and the company uses that dollar to make 10c each year. The classic example is a company with a share price of 100c that is earning 10 cents a share this year. This company is on a PE ratio of 10 times, or 10x.
A PE on its own doesn’t tell you too much, but it does appear to allow you to compare how cheap or expensive companies are compared to each other. It is a relative measure.
For instance, if you had the option to buy a company that cost twice as much as our 100c company, with a share price of 200 cents, but it was also earning 10 cents a share this year, you can see it will be on a PE of 20 times and it seemingly wouldn’t make sense to buy it compared to the company that cost 100 cents. Double the price for the same earnings.
And that’s what the P/E ratio would tell you. Our first company is on a P/E ratio of 10x, the second company is on a P/E ratio of 20x. On a straight comparison of price versus earnings, the second stock is twice as expensive as the first stock, and, by comparison, is expensive whereas the first stock is cheap.
Armed with this little bit of maths investors can now purportedly decide which stocks are cheap and which stocks are expensive. In fact all you need do is open the Marcus today All Ordinaries spreadsheet and sort by the PE column and the 500 stocks in the All Ordinaries index will separate themselves into the cheap and the expensive. Stock picking made simple.
Problems with PE ratios
But of course nothing is that easy for a number of reasons and it all has to do with earnings growth.
Certain sectors of the market are mature or in decline and are populated by companies whose earnings are only growing slowly if at all. Mature companies don’t see much in the way of earnings growth. So let’s say our first company is earning 10 cents per share this year and 11 cents per share next year. On that basis it has earnings growth of 10% and as we already know it is on a PE of 10x.
Now let’s compare that to a company that also costs 100c and is also earning 10c this year. This company is also on a PE ratio of 10x. They are, on the face of it, both fairly priced, they cost the same and they are earning the same amount of money this year.
But now I ask you, what would you pay for the second company if after earning 10 cent this year it is forecast to earn 12 cents next year, earnings growth of 20%. You would obviously pay more for this company, but the P/E ratio doesn’t pick that up.
And that highlights the major issue when comparing stocks on the basis of their PE ratios. Unless the companies you are comparing are identical in every way, including earnings outlook, strength of balance sheet, industry dynamics, risk and many more possible investment variables, you really can’t compare them on PE ratio alone and the P/E ratio becomes redundant as an investment tool.
To make the point there is a theory that if you take the 10 stocks with the highest P/E ratios in the ASX 100 at the beginning of the year they will always outperform the 10 stocks with the lowest P/E ratios. Here is a real-life example.
- The highest P/E ratios in the top 100 industrals at the moment include CSL, COH, DMP, RMD, REA, TWE, SEK, AMC, BXB, ALL, CPU, RHC.
- the lowest P/E ratios in the top 100 industrials at the moment include HVN, TPM, BOQ, NAB, CBA, WBC, LLC, BEN, TLS, AMP.
If it’s growth you’re after I think I know which portfolio I’d prefer to be holding, but the P/E ratio doesn’t tell you that, the P/E ratio is simply suggesting to you that the boring low growth stocks are the cheapest.
Other issues with the PE ratio include:
- Earnings per share numbers are a function of accounting standards and techniques. If for instance, as happened in the 80’s, management was paid a bonus depending on the declared earnings per share number, they could (still can) do all sorts of things to manipulate a higher published earnings number. There was a very good book about it 20 years ago called “Accounting for growth” by my old boss in London Terry Smith, all about creative accounting by listed companies “Stripping the camouflage from company accounts”:
- Some companies, like a lot of infrastructure stocks (AIA, TCL, APA, SYD), can’t be assessed on published earnings growth because having spent billions of dollars up front building assets. They then spend the next few decades minimising their statutory earnings, cutting them as close to zero as possible, using their huge depreciation and amortization provisions they have on the balance sheet, so they don’t pay tax on earnings. This is why a lot of infrastructure companies don’t rate on any “value” based analysis or intrinsic value analysis because the spreadsheets can’t work out how to treat a company that makes losses all the time. A lot of brokers, analysts, newsletters, will present these companies as showing no intrinsic value and they never recommend them because of it. It’s all a bit short sighted. They won’t turn up in a PEG ratio analysis either….not unless you clean up their underlying earnings which a lot of spreadsheets can’t and don’t.
- The other issue with a PE ratio is that it only relates price to earnings, not to risk. You could have two companies on the same PE but one has cash on the balance sheet and the other has 200% gearing. The PE tells you nothing about the balance sheet.
So we need something better and that comes in the form of what is called the PEG ratio, or P/E ratio to earnings growth ratio as opposed to the price to earnings ratio on its own.
The PEG ratio
This ratio relates the PE to the growth in earnings as opposed to simply one year’s earnings number and because the PEG ratio takes earnings growth into account, in the eyes of some fund managers, mostly active growth orientated fund managers, when it comes to filtering stocks on ratios, this is seen as the best filter in the business.
To calculate the PEG ratio you simply divide the price earnings multiple (P/E ratio) by the earnings per share growth rate for any particular share.
…where "g"=earnings growth.
“g” can be historic, the last reported earnings growth compared to the year before, but usually looks forward and uses the last reported earnings number compared to the forecast earnings number. It is expressed as a percentage.
Now if we look at our two companies, both costing 100c and both earning 10c per share this year but with one earning 11c per share next year and the other earning 12c per share next year, the PEG ratios look like this”
- Company 1: PE ratio = 100c / 10c = 10x. Earnings growth = 11c/10c = 10%. PEG ratio = 10/10 = 1
- Company 2: PE ratio = 100c / 10c = 10x. Earnings growth = 12c/10c = 20%. PEG ratio = 10/20 = 0.5
Now you can see how a PEG ratio is differentiating between two stocks because of their growth rate and that the lower the PEG ratio the better.
What is a good PEG ratio?
Generally speaking a PEG ratio of over 2 suggests a stock is expensive and a PEG ratio below 1 puts it on the radar.
If a PEG ratio of 1 is fair value, then a PEG ratio above 1 suggests that the share price is overestimating the growth in earnings relative to the rest of the market and the stock is overpriced. And vice versa, a PEG ratio under 1 suggests that the market is not pricing in the growth in earnings relative to the average stock.
You can imagine how, if you foolishly get carried away thinking that investment is as simple as looking at one ratio, then you might get this sort of conclusion, this comes off a broker’s website – it is a bit simple but you get the idea.
Karlk Siegling (MD and Portfolio Manager of Cadence Capital, a well known Australian stock picker) wrote an article about the PEG ratio a couple of years ago - here are some of his comments:
“Another way of thinking about this ratio is that it measures the price you are paying for a particular level of growth. What is really good about the PEG ratio is that it puts the PE multiple in a context of earnings growth rather than just earnings and forces the investor to think about the quality, security and consistency of earnings growth…knowing a company’s valuation (or basic PE) relative to a company’s earnings growth is far more valuable than just knowing the PE of a stock…It can be proven time and time again, and we can accept it almost as law, that should a company consistently fail to realise future expected earnings it will ultimately be worth less, and conversely, should a company consistently deliver strong earnings per share growth then it will be worth more….This is why analysts and portfolio managers, and investors in general, spend so much time trying to work out future earnings and future earnings growth for stocks. It is the future earnings and future earnings growth of a particular stock that ultimately determines whether the stock price will go up or down. I have to confess that I spent my first few years in the investment industry looking for ‘cheap’ stocks… on a PE basis…only to discover that just because a stock was ‘cheap’ on a PE basis did not mean it wasn’t going to fall in price…especially if earnings growth was non-existent or negative! I remain quite sentimentally attached to the PEG ratio. Once I fully understood the concept of being able to evaluate different types of companies relative to each other, the investment task became a lot easier. The PEG ratio allows you to compare a high growth company with a low growth company and still find value in both, if it exists.”
Marcus Today PEG ratios now on the All Ords spreadsheet
In order to help you sort the wheat from the chaff, I have now included PEG ratios on the Marcus Today All Ordinaries spreadsheet. Click here for that. You can now sort the spreadsheet by PEG ratio. But before you draw too many conclusions I’m not sure a PEG ratio has any value unless earnings are reliable and steadily growing. If they aren’t the “g” in the formula is a snapshot not a trend. If earnings are not reliable you would generally resist using a PEG ratio to compare stocks like resources with industrials, because the volatility of resources sector earnings numbers don’t compare to say a bank’s earnings volatility.
After you strip out infrastructure, resources and negative PEG ratios (making losses) the following industrial stocks in the top 100 or 200 turn up with PEG ratios below 1 (not many):
Interestingly this is a list of some of the highest large cap PEG ratios – some of the highest large company PEG ratios in Australia include Wesfarmers, Harvey Norman, National Bank, Commonwealth Bank, Westpac Bank and ANZ. Now maybe you understand why the bank sector is struggling to recover. It’s all about growth, and to spot that, the PE is useless and the PEG ratio is better.:
- Worth emphasising that a PEG ratio is simply one filter of many. Others might include free cash flow, yield, earnings sustainability, management, debt, balance sheet, size…the list goes on. I simply use it as a cross reference to make sure we’re not going wrong. And even where a PEG ratio is high, or low, you may be able to explain it away (one off losses or profits maybe).
- Another issue - as earnings growth approaches zero PEG ratios go exponential. So a PEG ratio of 245 doesn't mean its a terrible company or that it is 245x more expensive then a company on a PEG ratio of 1. It is just the maths of small numbers.