Watch PE when valuing a company

[FFNow]

What's your take on this, guys?

http://www.youtube.com/watch?v=wG6u5L0hC4Y

Personally, I don't like to use PE ratios as they can be manipulated easily by tweaking the EPS.

[Some-one]

Yes. It can be manipulated. As such, it can only be used as one of the several tools available for fundamental analysis.

[FFNow]

Yes. It can be manipulated. As such, it can only be used as one of the several tools available for fundamental analysis.

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

[Temperament]

To me, anything can be "manipulated" in a Company even for years.
One very good recent example is "Olympus".
Of course there were many extinct companies like "Enron"......etc due to "manipulation".
So when a company starts to manipulate its books, i don't think retail investors will be the first ones to spot it.
In fact most of the time we will be the ones holding the "baby".
Too bad that's how the market works most of the times.
IMO.

[freedom]

PE is the foundation of investment. But if you use PE as the only tool, it would be easy to be fooled.

[shanrui_91]

it is most important to understand why one is using the tool and not to use it for the sake of it. PER is still one of the ratio that I always use just that it is often used in conjuction with ROE, an assessment of earnings and FCF and other factors

[CityFarmer]

Yes. It can be manipulated. As such, it can only be used as one of the several tools available for fundamental analysis.

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

Yes, the video is talking about PE should not be the ONLY ratio used for valuation, not due to easy manipulation, but due to lack of full picture PE can give.

That make sense. That why we have taken in FCF, ROE/ROA, PB etc on top of PE

[Musicwhiz]

She's not quite right on this - a stock should be valued based on its expected FCF generated into perpetuity, and not earnings. Cash flows are the lifeblood of a company - earnings are merely accounting entries. P/FCF I feel, may be a better measure than P/E.

The Straits Times
www.straitstimes.com
Published on Dec 16, 2012
Watch PE when valuing a company
Markets jack up the price earnings ratio in expectation of growth and this, in turn, boosts the share price

How does the market value a stock?

Take the example of Groupon, the online coupon service provider. This year, its stock price sank by some 80 per cent - from above US$20 (S$25) to below US$5.

Back in 2010, Google wanted to buy Groupon for US$8 billion.

But Groupon spurned Google and went for a public listing instead. For a while, it appeared that Groupon had made the right decision.

On the first day of its trading, its shares surged to US$26, giving it a market value of US$16.7 billion. Now Groupon is only valued at about US$2.8 billion.

So within one year, nearly US$14 billion disappeared from the value of Groupon, the company.

How did that happen?

Well, it's got to do with market's expectation of its future growth.

Bloomberg reported recently: "As competition intensifies and demand wanes, analysts see (Groupon's) revenue growth slowing to 0.6 per cent in 2015, down from 45 per cent in 2012 and the 1,233 per cent average in the past two years."

It's rare to have a company that can sustain a growth of 30-40 per cent a year for a long time.

If it is a high growth market, you can bet that a lot of new entrants will be attracted to it - unless there are licensing rules or intellectual property restrictions to stop them from coming in.

Otherwise, new entrants would compete for market share, drive down prices, and crimp a company's growth.

When growth slows, valuation falls.

Stock analysts and the stock market use various methods or metrics to value a company.

The most common metric is the price-earnings (PE) ratio.

Say there is a coffee shop called ABC. This year, ABC raked in sales of $500,000. After deducting all its costs, the owner - say a Mr Tan - made a net profit of $50,000.

Next year, Mr Tan has a big marketing campaign planned for his coffee shop. With the campaign, he reckons he can increase traffic to his shop, and raise his prices as well.

He forecasts sales will go up to $725,000 and net profit to $65,000. Mr Tan wants to sell his coffee shop. How much would you pay for it?

If you pay $250,000, then you are paying five times the historical earnings of the coffee shop, or a PE of five ($250,000 divided by $50,000). Based on this past year's earnings and assuming it stays constant, you'll take five years to get back your initial investment.

If you pay $500,000, you are paying a PE of 10 times. This means you will take 10 years to get back your capital.

But if you believe Mr Tan's forecast, that the coffee shop's earnings will grow by 30 per cent to $65,000 next year, then a price tag of $250,000 translates to a prospective or forecast PE of just 3.8 times.

Potentially, you can get back your investments in 3.8 years, or shorter if the earnings continue to grow the year after.

So in expectation of the growth, the market will jack up the PE ratio today.

One theory has it that a stock should trade at a multiple equivalent to its sustainable growth rate.

If the company can grow at 10 per cent a year, then it should trade at 10 times earnings. Twenty five per cent a year, and the valuation goes up to 25 times.

But as we have discussed, growth is not guaranteed.

A lower growth outlook poses a double whammy for prices of high PE stocks.

Say ABC is a listed company with one million shares. So its earnings per share (EPS) is $50,000 divided by one million shares. That works out to 5 cents a share.

The market is bullish about ABC and is expecting it to grow its EPS by 40 per cent next year to seven cents. To take into account its fast growth, investors value the stock at 25 times its forecast earnings. That would put its share price at $1.75.

But subsequently the global economy slowed down, or news emerged that a new formidable competitor has entered the market.

Now the outlook for the company is less certain. Analysts start to downgrade ABC's forecast growth to, say, 10 per cent.

That would put its forecast EPS next year at 5.5 cents. Lower growth also means lower multiples of, say, 12 times. Hence, the share price would fall to 66 cents.

A 21 per cent downgrade in earnings forecast could lead to a whopping 62 per cent decline in share price!

What you want to be is on the other side of the equation. Buy a stock when it is trading at, say, five times its EPS of 5 cents, that is, at a price of 25 cents a share.

The following year, assuming the company makes 5.5 cents, the market starts to notice it.

Analysts become excited about the company and think it can grow its EPS by 15 per cent to 6.3 cents the year after.

And they think the company deserves a PE of 10 times because of its higher growth and consistent record.

So the price goes up to 63 cents. Voila! You've made 150 per cent return on your investment!

Next week, I will show the performance of consistently buying a basket of low PE stocks over a period of 22 years.

It's pretty impressive.

hooiling@sph.com.sg

The writer is editor of Executive Money, a weekly section in The Business Times. Her column is also available on BTInvest (www.btinvest.com.sg), a free personal finance and investment site of The Business Times covering five main categories: personal finance, wealth, markets, insurance and property.

Go to BTInvest for expert views on the latest market developments and tips on how to better manage your dollars and cents.

[freedom]

I still believe that to invest for long term, the thing looking at should be earning rather than FCF in general. For most companies, FCF is just following earning in the long term, and FCF is more volatile in short term with working capital change and capex. Most investors should not look at the rarely few companies manipulating earnings.

as you said, "Cash flows are the lifeblood of a company". Cash flow is more used to access whether the company can survive or not(survival is important, but should not be what investors focus on in the long term), whether the company is manipulating earnings.

e.g. Groupon talked about in the article. Its FCF is positive, but its earning sucks. I will never invest into it unless it is a special situation, e.g. it is going to be bought over by Google at significantly higher price.

[yeokiwi]

Teh Hooi Ling is one of the few decent financial writers around. I suppose, in this article, she is trying to write the article in layman terms so that most readers can understand.

In fact, buying low PE stocks has a good correlation to buying companies with high FCF. If the basket of selected low PE stocks is big enough, most of the stocks will probably satisfy low P/FCF requirements.

I do agree with her that, everything else equals, low PE stocks will give a good return in the long term.