*by KC Chong*

*“The key to successful investing is to relate value to price today.”*

PE ratio is the most widely used metric as a
measure of how expensive or cheap a stock is. Analysts and investment bankers use
this valuation metric in their valuation reports all the time.

Price-earnings ratios vary across sectors
with stocks in some sectors consistently trading at lower P/E ratio than stocks
in other sectors. It is generally acknowledge that stocks that trade at low P/E
ratios relative to their peer group must be mispriced.

P/E = Market price / Earnings per share (EPS)

The widely used of P/E ratio to gauge the
attractiveness of a stock is often justifiable as given below:

- · it is an intuitively appealing statistic that relates the price paid to current earnings.
- · it is simple to compute for most stocks, and is widely available, making comparisons across stocks simple.
- · it is a proxy for a number of other characteristics of the firm including risk and growth.

One big problem
with P/E ratio is which “EPS” is used.

- · Is it the EPS of the most recent financial year?
- · Is it an undated measure of EPS by adding up the latest four quarters results?
- · Is it the expected EPS for the next financial year?
- · Is it before or after the extra-ordinary items?
- · Is it based on the outstanding number of shares or all shares that will be outstanding when all warrants or ESOS are converted (fully diluted)?

Consider this
case of internet stocks at the end of the 20

^{th}Century. All telecom and internet stocks were trading at P/E multiples of high tenths or even more than hundred. If a particular internet stock is trading at a P/E ratio of say 50, was it considered cheap? I don’t.
Besides that,
all companies, even those in the same industries, contain unique variables -
such as growth, risk
and cash flow
patterns. Surely a company which has poor operating efficiencies, no potential
growth, a poor balance sheet should not be accorded a similar P/E ratio with
one which has superior earnings and cash flow growth, and a healthy balance
sheet. A company with strong market position in general generates more stable
earnings should be accorded with higher P/E ratio.

P/E ratio is
hence more likely to reflect market
moods and perceptions but this can be viewed as a weakness, especially
when markets make systematic errors in valuing entire sectors.

Figure 2 above shows the PE ratio distribution of S&P500 stocks on 31^{st} December 2013. |

As you can see above, most stocks are now trading
above a PE of 16. Hence a PE ratio of less than 16 may be good, below 8 will be
fantastic, but above 20 may be too expensive.

**Estimating fair PE ratios from fundamentals**

One way for the practitioner to do to solve this problem is to use the Katsenelson’s
absolute P/E method to find a fair value of P/E ratio for a specific firm which
we will discuss further later.

Here we will look
into a theoretical view of how P/E ratio is related to metrics such as return
on equity (ROE), dividend payout, growth, cost of capitals etc.

**P/E ratio: Theoretical background**

The financial theory postulated by John Burr Williams in his “The
theory of investment value” says the value of a stock is worth all of the
future cash flows expected to be generated by the firm, discounted by an
appropriate risk-adjusted rate. The simplest model for this purpose would be
the Gordon constant dividend growth model for a stable firm.

P

_{0}= DPS_{1}/ (r-g)__Equation 1__
P

_{0}= Value of equity
DPS

r = Required rate of return on equity

_{1}= Expected dividends per share next yearr = Required rate of return on equity

g = Expected growth rate in dividends (forever)

Divide both
sides of Equation 1 by expected earnings per share next year, EPS

_{1}
P

_{0}/ EPS_{1}= Forward PE = (DPS_{1}/ EPS_{1}) / (r – g ) = Expected payout ratio / ( r – g )__Equation 2__

Equation 2 shows that:

·
A higher growth firm
should have higher P/E.

·
A higher risk firm having a
higher cost of equity, r, will have a lower P/E ratio

·
P/E should increase when the
payout ratio increases.

·
Firms that are more efficient
about generating growth by earning a higher return on equity will trade at
higher multiple.

Note that the
above equation 2 is the fair PE ratio for a stable growth phase. For a high
growth company, you would have to estimate the payout ratio, cost of equity and
the expected growth rate in the separate phase of high growth and the stable growth
period, and summing up the value in these two phases taking the time value of
money into consideration. This approach is general enough to be applied to any
firm, even one that is not paying dividend right now.

**Investing using the low P/E ratio strategy**

Tons of research has shown that investing in low P/E
ratio stocks have yield extra-ordinary returns when compared to the broad
market. However just basing on P/E ratio alone is not a desirable way as P/E
ratio theoretically depends on a number of factors. It is possible that these
low PE stocks are riskier than average and that the extra return is just a fair
compensation for the additional risk, low future growth rates and poor quality
earnings. One can improve the strategy tremendously with some screening works
based on the discussion above as below.

- Low P/E ratio with
respect to the prevailing market, say not more than 12
- Low idiosyncratic risk
as measured by debt/capital ratio, of less than 0.6, current ratio of more
than unity, and interest coverage ratio of more than 3.
- Reasonable expected
growth in earnings of more than 5%
- Historic growth rate in
past 5 years of more than 5%
- Good quality of earnings
with reasonable cash flows

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