Watch PE when valuing a company

[specuvestor]

PE is a simple rule of thumb to estimate payback period. A simple ratio can never capture a good picture, be it PE, EV/EBITDA, debt/equity etc.

Simplistically if we assume an asset was bought for $10 and generates $1 FCF annual with 10 years depreciation, the earnings of the asset is zero after depreciation. However if the asset is actually able to generate FCF beyond 10 years, then that is where it could be undervalued. In addition if Mr Market sells you this asset at $5 for zero accounting PnL, it may make sense for 20% ROIC even when ROE is zero. It doesn't even need to be a turnaround situation.

[FFNow]

Not suitable to apply PE ratio on property/construction, or turn-around companies.

I understand why property and turnaround companies shouldn't be valued using PE. But why not construction companies? Thanks.

[Stocker]

Not suitable to apply PE ratio on property/construction, or turn-around companies.

I understand why property and turnaround companies shouldn't be valued using PE. But why not construction companies? Thanks.

Jobs for construction companies can be erratic, at time booking of revenues can also be very lumpy.

[ashparagon]

Yes. The video is talking about something else though. It pays to watch if you haven't.

That guy in the video said if 2 companies have the same PE at 10, ROE at 20%, share price at $2, in fact everything the same, except that company A pays all the profits in dividends while company B don’t pay any dividend, which company gives you more in 5 years time? The answer is company B. Because company B gives you 20% return of your money while company A only gives you only 10%.

My question is how is that company B gives you 20% return 5 years later?

[ashparagon]

Guess there is no end to research to a company to find a truly undervalued counter, most of time I am staring at the pluses and minuses of what I found out and realized that the hypothetical undervalued price, one with high safety margin might never come... So, cash and portfolio balancing become important. No end to learning. It is and never going to be a magic matrix for investment. The more I learn, thro books and forums etc, the more insecure I feel about investing. Weird...

Exactly how I feel right now! =/

I think for the pluses and minuses, you have to determine which are the more important factors and which are less important. Then at the end see which side it's weighed towards.

And also don't over analyse! Haha

[orangetea]

IBM buys back shares, reduces outstanding shares, improving EPS, bringing PE down.

That is good financial engineering.

[BlueKelah]

Guess there is no end to research to a company to find a truly undervalued counter, most of time I am staring at the pluses and minuses of what I found out and realized that the hypothetical undervalued price, one with high safety margin might never come... So, cash and portfolio balancing become important. No end to learning. It is and never going to be a magic matrix for investment. The more I learn, thro books and forums etc, the more insecure I feel about investing. Weird...

Exactly how I feel right now! =/

I think for the pluses and minuses, you have to determine which are the more important factors and which are less important. Then at the end see which side it's weighed towards.

And also don't over analyse! Haha

Tip for you, P/E is a useless ratio for a value investor.

[Clement]

Yes. The video is talking about something else though. It pays to watch if you haven't.

That guy in the video said if 2 companies have the same PE at 10, ROE at 20%, share price at $2, in fact everything the same, except that company A pays all the profits in dividends while company B don’t pay any dividend, which company gives you more in 5 years time? The answer is company B. Because company B gives you 20% return of your money while company A only gives you only 10%.

My question is how is that company B gives you 20% return 5 years later?

This example requires the assumption that the business is scalable and that earnings growth is roughly going to be roe x (1-payout ratio). In this case, growth will be 0 for company A and 20% for company B.

Assuming you buy 1000 shares,

The company that does not reinvest it's profits is assumed to have 0 growth and therefore will earn $0.2 per share for perpetuity. Assuming you reinvest all dividends at 10x PE, after 5 years, you will have $3220 (1610 shares at $2 a piece, 10 x PE)

The company that reinvests will earn 0.2(1.2)^t per share, where t is the number of years from now. Now after 5 years, the company is now earning $0.5 per share and applying a 10 x PE, price is now almost $5, effectively compounding your investment at 20%.

[Temperament]

Rojak Investor like me will never rule out any financial ratios- Only how to use it to complete the whole picture of investment. In fact, never rule out anything in the market. Because anything is possible in the market.
Another words, there are so many different people in the markets making money in so many different ways. If i only know some of their ways. You may be a "Specialist" but i am a "ROJAK" because i am what i am.
Shalom.

[ashparagon]

Thank you for the detailed explanation Clement! I realised if the ROE is 10%, then it won't make any difference.

In essence, it seems like if a company is expanding and doing well (able to maintain high ROE with more capital pump in), then it's better for them not to pay out dividends. However, few companies are able to maintain a consistently high ROE for extended period of time. Furthermore, dividends payout are important as it show that the company has real cash and are able to reward the shareholders.

What factors/ underlying conditions will make you guys invest in a company that don't give (or give very little) dividends?