Do low P/E ratios mean bargain buys?

[KopiKat]

A lot of investors are "book smart" investors, they only looks at the numbers but rarely the qualitative aspects, such as what is the management like? The problem with numbers is that while there is auditing and all, numbers can always be fudged by a expert numbers player. This has been shown time and time again.

Each management has a particular style of running their company / organization, understanding how the management runs the company, their track record , etc helps you understand and trust the decisions they make. Some run a risky game, some are conservative, some are bottom line oriented and that's all they care about, some are employee oriented and believe through that, they can achieve more etc...etc...etc...

Ultimately, you can crunch all the numbers you want, but a bad management can in a second turn a good company into a bad one by the decisions they make and vice versa.

Agree?

Hi Flinger,

While I do agree with your observations and comments, I must emphasize that assessing Management is pretty tough. I am sure d.o.g. (in his job) has access to many high-profile managers and CEOs and it's not always that obvious which are hiding fraud, which are incompetent or which are candid. I myself have been to a fair share of AGMs and met up with Management and CEOs, and also interacted with many top level people in my job capacity; all I can say is that it is hard to discern dishonesty and lack of integrity just from a few meetings. At most, you can tell if they are competent or incompetent in the way they allocate capital or conduct operations, but it's tough to gauge if Management is actually hiding something.

That's why even though I fully agree with the methods ascribed by Philip Fisher in 'Common Stocks and Uncommon Profits', I'm constrained (call me lazy) at this point in my life (already no social life as my time is dictated by my 'bosses' - my young kids).

At most, I try to visualise/imagine the type of management from Financial Reports, News and Analysts' Reports. For eg. when it comes to debts, whether they are conservative/aggressive and in whatever they are doing, whether it's for the shareholders' interest or their own interest (esp. for REITs and other Trusts). As a long term holder for some stocks, I think I'm able to build up a quite good picture or get a good feel after a few years, esp. if the CEO don't get changed every 1-2 years.

[redcorolla95]

There're different styles of value investing. One is concentrating all the positions to just 5 positions like Buffett in 60s, or buying in the hope of 10+% growth and in which case, evaluating management would be pretty important. Another kind is buying 50 cheap things like Graham & Schloss, in which case they make no attempt to meet or understand management.

While written for the layman, it's still a shame that the original article did not go further to explain that low PE was not valid for their examples because they're contractors & developers with lumpy earnings.

[Temperament]

The current P/Es of all the stocks in the market are determined by all type of players in the market.
So i think the P/Es of stocks that are more truthful/accurate are those determined by more fundamental players and ignore by short term players. Sometimes by monitoring a particular stock for months/years, you will know more or less why the market has such a PE for such a stock most of the time.
The question is how to spot the more accurate P/Es stocks?

[freedom]

some thought about PE, PB and ROE.

IMO, the most important thing to value a company is its book value and its ROE. Ultimately, what the investors would get back is the book value of the company at that time. PB is the ratio the investors is willing to pay now for the future value of the issue. Assume, the current book value is E, the yield (discount) the investor demands is d, the ROE is r (a constant, which will be later adjusted with another coefficient). The future book value of the issue after n years would be ((1 + r)/(1+d)) ^ n * E. so the PB would be ((1 + r)/(1+d)) ^ n. Given the volatility of earning as well as risk of highly anticipated ROE, we assign another coefficient c for the future value. So the PB would be ((1 + r)/(1+d)) ^ n * c. since PE = PB/ROE, we can get PE of ((1 + r)/(1+d)) ^ n * c / r.

From the simple assumption and calculation, we can easily conclude that, the higher the volatility is, the lower the PE should be. the lower the ROE is, the lower the PE should be as well.

so does low PE alone mean bargain? not necessarily. maybe just because the company has or is going to have a very low ROE or the earning from the company is too volatile.

[Temperament]

Every company has its unique way of operating. Some operate on a lot of debts, some very little on debts and more on equities. Some are quite balance on both - debts & equities. Another words, the capital structure of a company is not so easy to understand. Why the market accepted some companies to operate on a lot of debts, while some must be on a lot of equities and some balance? So can we use ROE across all types of companies?
Am i correct also to say base on the current data ROE of a company - the higher the ROE, the more people want to own this stock. The more people buying this stock, the more the current P/E goes higher(so is P/B) and its dividend yield going lower. In fact this stock may be so hot that i usually look in amaze. My jaws wide open. At what P/E should fundamental investor stop joining the crowd?
So do higher P/Es stocks necessary should be avoided?
Just like low P/E stock is not necessary a good buy.

[freedom]

I tend to believe that ROE is the most important valuation factor. A consistent high ROE company is the best company one can ever have given the right price for a long term investment. with longer years projection into the future, the risk factor will weigh more and more. It will reach a point that it is difficult to justify the higher PB value. What is the right price or margin of safety, it is up to everyone to decide.

[Temperament]

O. K. When ROE is high, a lot of people will want to own this stock. But how to value company that operate on a lot of debts and very little equities? And the market seems to accept this stock also?

[freedom]

there are enough company with high ROE and good balance sheet, why focus on those without a strong balance sheet.

how market prices a security should not concern too much about value investors.

[Temperament]

I agree high ROE and good balance sheet. But some companies choose to operate on high debts rather then equities because most probably they think this is the most efficient capital structure for their type of business. But yearly, they may have good earnings, cash flow and high dividend yields.
Are value investors to ignore them? i am trying to understand these type of companies why they can operate and survive. Where are their values?

[Musicwhiz]

I agree high ROE and good balance sheet. But some companies choose to operate on high debts rather then equities because most probably they think this is the most efficient capital structure for their type of business. But yearly, they may have good earnings, cash flow and high dividend yields.
Are value investors to ignore them? i am trying to understand these type of companies why they can operate and survive. Where are their values?

There is no such thing as an "optimal" capital structure. Most companies will continually tweak their Balance Sheet according to what they feel is best for a balance of growth and recycled working capital. Of course, there are companies that tip both ways; retaining too much cash (e.g. GRP) and being overly aggressive and leveraging up to expand and grow (e.g. Ezra). WHat is most important, I feel, is that the capital structure of a company is conservative and not overly aggressive. Cash flows have to be healthy and debt levels have to be manageable. Manageable is again subjective but here's an illustration: if you generate say $20 million of profits a year and your finance costs amount to say $15 million, that would qualify as over-aggressive, and this indicates a very risky profile which a value investor should avoid.

Healthy cash flows and profits should be seen in light of company-specific circumstances. FCF and healthy high unleveraged ROE are of course very much sought after, but if these cannot be achieved then one should evaluate if the next best thing is really as healthy as it seems....