Valuing Stocks–Price Earnings Ratio Explained the Kyith way

One of the most prevalent ways, but also the easiest way to screen for stocks is to use the Price Earnings Ratio. It is popular because its so easy to come up with this ratio to screen for “Top 50 cheapest stocks on the stock exchange” or “Top 50 most expensive stocks on the stock exchange”

The mantra is to buy cheap and sell expensive, so if we have something that saves us a ton of time to find cheap stuff, then why not use it??

If using such measure as a valuation is so straight forward then everyone would be making money just by using it. However, not all are.

To me, if you are using metrics like this to assist you in determining valuation, you need to develop a little appreciation of it.

I will go through a bit how I appreciate PE and some stock examples which I use PE to prospect in the past.

1. What is made up of

The Price Earnings ratio is computed by = Price of the stock / Earnings per share of the stock.

This formula is by a share basis so if you want to look at it as a company, it is rather similar to = Market Capitalization of the stock / Net Income attribute to share holders of the stock.

Price Earnings ratio tells whether the stock is expensive or cheap.

Look at it in a different way, it tells you: how many years the company is going to earn back the money if you pay for it today.

Example:

The current trading price of a stock is \$1.00. The earnings per share last reported is \$0.25. The PE in this case is 4 times. Assuming the earnings per share is the same, it means if you buy the business behind this stock at \$1.00, you will get back your money in 4 years.

Fast payback!

In another case if the stock is \$1.00 but the earnings per share is \$0.05. The PE is 20 times. Assuming earnings per share is the same throughout the period, it means if you purchase at \$1.00 you will get back your money in 20 years.

Now you see why low PE seems the way to go.

Price Earnings ratio is used as a tool to compare against something to see if the stock you are evaluating is cheap or expensive.

2. Time Frame

However, whether a stock is expensive or cheap depends on your time frame. A stock’s price earnings ratio today might differ from that 2 years ago, or even 1 week ago.

This is because the price, which is traded on a stock market moves up and down. The stock market is a voting machine, or a fish market. Prices are bidded up and down by folks who know what is the value of the fish they are buying but also by novice Ah Lians who is first time buying fish and do not know what is the  right price to pay for fish.

The earnings of the stock also moves up and down.  Depending on the nature of the business, not all business earns the same amount.

The 5 year earnings of  different businesses may look like this:

 Year 1 Year 2 Year 3 Year 4 Year 5 Order book business (Nam Cheong, Vard,Semb Corp Marine) \$1000 \$50 \$10,000 \$7,000 \$1,000 Recurring matured operating business (Sheng Siong, SATS, SIA Engg) \$1000 \$1050 \$1075 \$950 \$1200 Recurring growth operating business (RMG, Breadtalk, Silverlake) \$1000 \$1200 \$1600 \$1500 \$2000 Asset Rich, Poor operating business \$0 -\$50 \$50,000 \$200 -\$100

If you look at it this way, knowing the nature of the business is rather important to appreciate the E component in PE.

You cannot just say

“Oh its PE is 4 times, its cheap! Let’s buy!”

or

“Oh! the PE is 25 times! I will never be suckered to buy something so expensive!”

Different time frame different PE.

3. Which earnings matter

What you are concern with are the earnings going forward.

If you are buying the stock today, you are concerned with what the business is going to earn for the next X amount of years NOT what happen in the past.

So why do we look at the past financial statement’s earnings? This is because more often then not, most business is going to operate like how they used to in the past.

When you look at the past financial statement you are trying to get a sense of what kind of earnings is the business, is it an orderbook one, a growth recurring operating business, or a business without any earnings.

Knowing the past lets us have an idea of the earnings going forward, the quality of earnings going forward, the recurring nature or non-recurring going forward.

But we are always concern with the earnings in the next few years.

4. Earnings grow, stop growing or becomes bad

Remember our first example where I said “Assuming earnings per share is the same throughout the period, it means…..”

The reality is that not many business earnings stay the same. We lived in a fluid world. The stock price gyrates so does the earnings.

There are recessions, there are bad management decisions, there are good opportunities, there are great executions, and so different business earnings changes.

To build on to which earnings matter, if you are looking to own a good business, what you need to be concerned about is the earnings and earnings growth for the next 5 to 7 years.

5. Why concern with only the earnings for the next 5 to 7 years?

Its not that we are concerned about ONLY the earnings of the next 5 to 7 years, its that the earnings of the 5 to 7 years is more valuable than 8 years out.

Due to inflation, the value of money in the future is smaller than the value of the money today.

Although your business can earn \$100 for 20 years, at an inflation rate of 3%, the \$100 in year 18 would buy much less things than the \$100 in year 2. This is what is termed time value of money if i am correct.

The price you pay for the stock buys the value of the business behind the stock, and the value of the business is the summation of the future earnings of the business.

So the way to look at the earnings is to not look at it as earnings for 1 year, but across perhaps 5 years, 7 years or 10 years.

6. A PE ratio of 20 times is NOT expensive if…….

Its easy to say “Raffles Medical Group is so bloody expensive at 30 times PE or GoPro is at 40 times PE, the folks that buy this is out of their f#\$king minds!”

At this point we have stated:

1. You have to look at earnings going forward
2. You have to look at the nature of the earnings
3. You have to look the growth of the earnings

20 times or more is not expensive if the business is growing a an astounding rate.

Suppose you purchase a stock at \$1 and the earnings is \$0.05 this year. The PE is 20 times.

The business grows earnings at 20% for the next 4 years. The earnings per share is \$0.10368. The forward PE ratio then is 9.64 times.

Looking at it this way, paying \$1 for a forward PE of 9 times doesn’t look that expensive versus the price you pay now.

I did a tool some time ago to help me visualize the growth rate and how cheap or expensive asset gets for the price earnings we paid for it.

(click to explode this image)

Suppose you are evaluating whether the stock is a good purchase at PE 20 times. If you invert 20, the earnings yield is 5%. Investing earnings / price you get the earnings yield.

Whether that is cheap or expensive depends on the supposed growth rate.

Under Individual Year Growth Rate, we have about 8 simulations of yearly growth over 20 years.

On the right side, shows the PE and earnings yield at the end of 5 years, 10 years, 15 years, 20 years.

If the next 20 years, earnings stagnate and doesn’t grow (0% throughout) the PE and yield stays the same. This doesn’t look cheap.

If the next 20 years, earnings grow at 3%, which is roughly the base case for majority of the business, since that is roughly the GDP growth rate, after 5 years the PE is 17.25 times and 10 years its 14.88 times. That looks fair. It is reasonable to pay at this price for that, but you may not have much margin of safety.

At 5% for the next 20 years, it looks interesting, in that although after 5 years, the price you pay looks fair, but after 15 to 20 years, the earnings yield at 10% and 13% looks great as a compensation for sticking with this business. A good example perhaps is SIA Engineering, depending if you think it will grow at the rate of the industry which is 5% and they can maintain their competitive edge.

The 5th simulation is that of a growth company. This is a rather outlier. What if you have a business that grows at 10% for 10 years and then to be conservative they don’t grow any more?

The 10 year PE gets down to 7.7 times and stay that way and you enjoy an earnings yield of 13% or more. One business that you can look at it this way could be Macdonalds in the past years.

The best form of return is the 7th simulation, where the earnings grow at 25% for 2 years, 20% for 2 years and 10% for the 5th year. This is a high growth company. What was an expensive PE 20 times and 5% earnings yield becomes 8.8% in 5 years and 11% earnings yield. Business that fall into this category can be your Biosensors, Nam Cheong or Cosco, typically high growth business that goes through some astoundingly great 5 year up cycles.

7. Can businesses have that kind of growth for 20 years?

I have no idea. You have to figure that out.

This goes back to your appreciation of 3 Which earnings matter and 4 Earnings grow, stop growing or becomes bad. If you can’t discern earnings SO far out, then don’t trust the figures for 15 years or 20 years out. It is not going to help you. It will just give you a false sense of security.

People like to buy blue chips because over the long run, they should grow based on the GDP, so in my above illustration is the 3% for 20 years illustrations. If that is ST Engineering, is that good enough for you since their PE is always above 20 times?

8.  A particular good or particular bad earnings year

If you do not appreciate the Price Earnings ratio by understanding it this way, you might not get yourself out of a bad stock or you will get yourself out of a good stock.

What does this mean?

Businesses go through challenging times. Can’t be every year they do well. Suppose you screen for low Price Earnings stock and chance upon this stock call Riverstone.

They just announced a splendid earnings recently and based on full year earnings the PE is 13 times. That price looks not bad, but could this year be the peak earnings, an earnings level that won’t be repeated for some time?

You purchase the stock based on last year’s earnings thinking its not expensive. For next 4 to 5 years, the competitors to Riverstone wised up, coupled with raw material prices going against them the earnings plunge. What you think was cheap becomes 23 to 24 times PE. A not so expensive stock becomes rather expensive.

On the other hand, you can have a business that is going through some growing pains. They have to take a one time operational expense, or a higher administrative expense just to ramp up capability. This will make the PE look rather expensive at 25 times, but for the next 5 years, they do not need to spend so much expense any more.

What looked expensive based on this one year snapshot doesn’t look that expensive anymore.

If you are purchasing the business, it goes back to understanding the earnings over time, what kind of earnings in the 2 Timeframe table above.

9. Average out inconsistent earnings

Some business such as orderbook business are rather inconsistent in earnings, and to be honest I would rather steer clear of them. But if you want to measure up against competitors, perhaps average out the earnings over a long period and it might provide a fairer evaluation rather than take one year to avoid the problems mentioned in (8)

10. So what PE is cheap, not expensive, fair or expensive

Up to this point, I think you get the drift, that a lot depends on the appreciation of earnings.

But as a gauge you should compare the PE in 3 ways:

1. Against the competitors in the same industry
2. Against the nature of the earnings
3. Against a historical require rate of return, versus other assets

Competitors in the same industry

The first one makes sense because you are comparing apples to apples. We talk about the nature of earnings, and it is likely those companies in the same industries are governed by the same operational situations and thus the nature of earnings are the same.

If its Riverstone you are comparing against Top Gloves and Hartalega in Malaysia.

Nature of Earnings

The second one goes back to the table in 2 Timeframe. Generally,  if the whole freaking world knows the earnings is consistent over the next 10 years the PE should be higher. This is why blue chips typically trade at a higher premium.

If the whole freaking world knows that some businesses going forward, are not going to see consistent earnings, they should trade at a lower PE. This is probably for a lot of cyclical semi conductor, shipping business.

Historical required rate of return, versus other assets

The third and last way is to measure them against the historical return of what is considered cheap or expensive, but also against other assets.

The historical metrics of less than PE of 10 is cheap, more than PE of 20 is expensive holds some ground, if you have a good appreciation of the earnings in mind.

When comparing against other assets, it is difficult to find assets that earns consistently above 10% yield. The average equity returns are 6-8% and bonds 4-5%. Inverting a PE of 10 gives you 10% earnings yield.

If you can consistently get more than a 10% yield conservatively, then it looks attractive.

Note the word conservative, in this case what I would do  is identify based on the understanding of the business, what is the lowest earnings the business can generate, or the lowest average earnings.

If this lowest earnings, at this price I can get a 10% yield, it looks attractive.

Good typical low earnings estimates are from recession times such as 2000-2002, 2009. But note, some businesses run a different cycle so using those financial crisis earnings might not always be a good idea.

11. Straco

Straco is one of the stocks that I personally own that taught me quite a few lessons in the past. Most notably, it taught me to focus on the business and the earnings nature. If I focus on the price I would be happy to sell it at \$0.34 cents which would doubled my initial purchase at \$0.17.

When I first bought, I have an idea that its historical earnings was consistent. But back then, I am not as well versed as I was now. There are also much doubts over how sustainable the earnings is. So I didn’t purchase much.

When it reaches \$0.30, the important thing sometimes is to search for prospect where you have searched before, and that is your existing businesses. If you got into them in the past, there is a reason you would get into them again.

We realize that we missed out on appreciating the earnings growth in the past. The visitors growth in China can be rather crazy!

The first purchase in 2011 at \$0.17 was when earnings is around \$18.6 mil. The PE was 8.7 times.

In 2013, there is another batch of purchase at \$0.26-\$0.31. The earnings was around \$19 mil. The PE was 12 times.

Its not easy looking at things as a business when you have a paper gain of nearly 100% sometimes, but if we don’t look at it as a business, I would have sold it then at that price or perhaps \$0.40.

In my last add at \$0.72, the earnings was \$35 mil. The PE 17.9 times. That is not cheap. I bought on the idea that growth is intact, Mr Wu and his team are good managers, and they can turn around a little amusement call the Singapore Flyer.

Today the share price is at \$1.04, but the forecast full year earnings (might be wrong!) can be \$55 mil. The PE is 16.45 times. Not cheap. Again.

Some how good business do not go on forever, and I remain surprised year on year that folks will think this is a scam.

The lesson here is not that it worked out well for me, but that what looked to be expensive at \$0.72 cents turn out to be not so much now (if the earnings can keep up on a consistent basis) The PE of earnings at \$55 million  at \$0.72 cents is at 11 times.

If you purchase a good business at a  not so expensive price at first glance, you better make sure that the growth rate in the future is really going to be there and not something your brain imagine it to be.

12. SIA Engineering

SIA Engineering was something I profiled some time ago. It can be considered a rather established business in Singapore, doing maintenance, repair and overhaul for mainly SIA but also other airlines.

The earnings and cash flow are recurring, but most of the time the PE is around 20 times, and when you pay out 5% or so dividend, this looks good.

The long term growth rate of the industry is 5% so if you look at it from a 5 year or 10 year perspective, it doesn’t look a value purchase, but for a consistent earnings business over 20 years its not bad.

You also learn the story of a possible one or two bad years when in the past year, it bleed negative free cash flow.

Apparently what was a really good recurring business, the OEM players are looking to edge in as well. And the OEM held a lot of the pricing power.

Is this going to affect SIA Engineering 20 year earnings growth out look? Its your job to figure that out.

13.  Rickmers Shipping Trust

Rickmers seem to be a stock that I have had a lot of enquires emailed to me from readers. This is because according to my Dividend Stock Tracker, its yield is 10.3%.

That looks very appealing yield wise and PE wise.

If you purchase based on that tracker and not looked into its earnings or free cash flow profile, you would have expect earnings like this to go on forever.

Rickmers owns ships and charter out ships over short or long durations.

Their issue is that many of their ships were chartered out prior to 2007. Somewhere before 2007, shipping was in a super peak, and the rates was crazy high.

Some of Rickmers ships were charter for long duration at that rate. The rates now is estimated to be at least 70% below that crazy peak rates. 2 of their ships’ charter is expiring soon.

So the question is: can you use the current earnings as part of your valuation?

14. Keppel Corp and Sembcorp Industries

Keppel Corp and Sembcorp Industries are both blue chip stocks in Singapore. Some time at the start of 2015, oil prices have a good fall. With that the whole supply chain dealing with oil and gas had a good fall.

The idea is that majority of the business requires oil prices to be in a certain range, and without high oil prices, business is affected. With that, capital expenditure is cut and many of the downstream businesses will have reduce revenues.

A big portion of Keppel Corp and Sembcorp Industries business is in building advance rigs or ships that caters to the industry. These rigs and ships are usually used in deep sea exploration, which, in the absence of high oil prices, need to cut down.

Keppel Corp’s majority earnings is in this portion, and the smaller portion is in properties, which is also an orderbook business. For Sembcorp Industries, the other portion of their business is in utilities, which is somewhat recurring.

The price fall in both companies presents an opportunity, and it is something that I would have bought 3 years ago.

Now, I am more sceptical in the way I see most things.

While on a price earnings basis, both look way below their historical norms and in Keppel’s case it hit a PE of 8.4 times. For a blue chip that looks very valued.

My thoughts are more tuned towards the general trend of their business, rather than the oil price.  Oil prices will gyrate as they do and I believe they will stabilized higher.

The rig building business have been great for the  past 15 years and it gives people the impression that this industry is recurring, that there will always require rigs. Sembcorp and Keppel could be in a better position consider that their rigs are not low value ones and are rather advanced.

What if the replacement cycle for rigs is over? Take a look at 1980s to 1990s

What if what needs replacing have already been replaced?

I am not in the industry, and even those in the industry, their view might be rather slanted since those that have 10 years of experience are still within this boom cycle.

Keppel’s purchase of Keppel land is mainly orderbook based and the only part likeable is the asset recycling aspect

For these 2 companies, the main earnings still comes from this boom industry.

I am still thinking over this. If i cannot figure out the earnings forward, let it be. What look cheap at 8 times PE might not be so cheap after all.

Summary

Price Earnings ratio is simple yet complex at the same time depending on the eye of the beholder.

I think this article serve more as a summary for myself, should some of my acquaintance asks me how I look at things so that I can just dump this to them.

If you enjoy this, you might like my look at valuing growth companies via discounted cash flow, and instead of earnings, use free cash flow or other cash flow metrics instead.

To get started with dividend investing, start by bookmarking my Dividend Stock Tracker which shows the prevailing yields of blue chip dividend stocks, utilities, REITs updated nightly.

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penny dividends

Sunday 7th of June 2015

Very insightful and educational article on P/E ratio! Many takeaways from this article!

SMK

Monday 11th of May 2015

I like this article. I wish you do more of these. I would also like to see you add in some of the non-business related ways that affects PE but that is asking too much. Good job!

Kyith

Tuesday 12th of May 2015

Hi SMK,

Thanks for letting me know. Some of these articles are due to something burning inside that I have to write about. When i see there may be an unhealthy trend happening. I hope I can provide more of these content. Been sometime since I wrote much on business prospecting. Whenever I want to write, I feel lazy cause my brain tells me there are so much stuff to cover!

Yeo Sui Chuan

Monday 11th of May 2015

Good, detailed article with many nuances which are not frequently covered. Thanks Kyith.

Kyith

Monday 11th of May 2015

Hi sui Chuan,

Thanks. I hope I can answer some of the questions in folks thought when looking at the figures.

LP

Sunday 10th of May 2015

Thanks for the very educational article on PE. I like the way you look at the quality and not just the quantity. Not so straightforward a ratio as pple deem at first glance. Great article!

Kyith

Sunday 10th of May 2015

or people could say i am being very philosophical with it.

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