Valuation, Valuation, Valuation - Bursting for a P/E - Part 1 of 3

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Don’t panic, I haven’t morphed into Tony Bliar; although I have been drinking the odd beer or three tonight and maybe we could all do with some “Education, Education, Education“. I am very aware that in recent weeks I have been nonchalantly discussing and tweetering about ‘Valuations’ being on the high side and I often bandy this term around, but I perhaps haven’t really defined in detail what it actually means.

I am pretty sure that I have regularly referred to P/E Ratios (Price/Earnings Ratios) and Valuations in various Blogs etc. but I don’t recall ever doing a Blog which is pretty much dedicated to the P/E Ratio and what it means and how to interpret it. It has certainly come to something when I have bashed out so many Blogs that I am starting to forget which ones I have written and which ones I haven’t - throw in some Old Speckled Hen and a sniff of Alzheimers and I guess it’s not such a huge surprise (if you go to the ‘Useful Links’ page and scroll down, you will find the Full List of blogs published up to now and I strongly suggest that people who are new to the whole WD malarkey have a nose through - there is a lot of useful stuff in there I believe.)
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And besides, if I have written about P/Es already, this is such an important subject that perhaps a repeat wouldn’t hurt too much anyway. I will drum it into the Collective WD Readership Psyche one way or another……

To illustrate the importance, I think that in my early years of ‘Investing’ (more like utterly random picking of Junk Stocks from a Random pool of more Junky Stocks) I had zero understanding of Valuation and my primary method of picking Stocks was reading Tips from Shares Magazine and copying the Stocks that my mates were buying - and remember these were the Dotcom Boom days which quickly turned to Dotcom Doom…..

I lost a huge amount of Dosh in the early years and it was only after some time that I realised it might be a good idea to learn what I was actually doing. I am really thankful that I took this course of action because I have since enjoyed my Investing activities and got a huge amount out of it - not just in Financial Terms. Many of my friends gave up Investing and this is in reality the worst mistake you can ever make - some of them then moved on to Property and have done very well out of it - but I don’t think any of them get any enjoyment from it and it seems just a set of grindingly tedious chores leading to more of the same. And of course these people are rich on paper but it is not much use unless you sell the house and all it means is they are miserably servicing the day to day problems associated with Maintenance and Tenants.

I have no doubt that understanding Valuation in terms of P/E Ratios was a major leap forward for me and I cannot stress enough that getting a full and intricate understanding of the contents in this Blog will give New Investors a huge Edge in making money from the Stockmarket - it is probably the most important concept to master.

I suspect many Experienced Investors will find a refresher useful as well. It has certainly been useful for me to be forced to write a Blog Plan and to start trying to explain these critical concepts in a hopefully understandable way.

If you can get a grip on how to Value a Company then it will help you exploit times when the Markets throw up Under-Valuations and also enable you to realise when Markets have created Over-Valuations - to a large extent the latter is where we are today in my view.

It is also probably the case that Valuation is a concept that is perhaps under-rated (more like misunderstood in my view) and I often hear comments from people along the lines of “Valuations don’t matter” - I just don’t buy this, to me Valuation ALWAYS matters and when we get in circumstances like the present when Share Prices have generally run too high, then recognising this Over-Valuation is extremely useful. The worst thing you can do is buy an Overvalued Stock and if you can recognise Over-Valuation, then you can Sell or at least TopSlice some Holdings. 

Remember, “Buy Low, Sell High” - and understanding Valuations enables you to do this very effectively (and throw in a bit of basic Chart understanding and you are well on the way).

I have so far concentrated on P/E Ratios, but there are other ways to value stocks which I will discuss later in the Blog series.

How to Calculate the P/E Ratio
OK, first important thing to realise is that there are sort of 2 basic types of P/E Ratio - the Historic P/E and the Forward P/E. The Historic one is based on Actual Earnings that have been reported and the Forward P/E is based on Earnings Forecasts - and this can be 1 year out or even 2 years out etc. For myself, I don’t find the Historic one particularly useful and I am more focussed on the Forecasts and the Forward (Future) P/Es. More useful for me from the past is the Growth Rate and progression of Profits and Revenues.

And to add to the complexity, there are sort of 2 ways to calculate the P/E (whether Historic or Forward). In the first one (and I pretty much always go this way because it is easy and logical) you divide the Current Share Price by the Earnings Per Share (EPS) and in the second method you divide the Market Capitalisation by the Profit After Tax. They amount to exactly the same thing in Ratio terms but I personally find the EPS method easier (it is also worth noting here that it is important to make sure you are using the same Currency - for example, you might be using a Share Price in Pence but the EPS might be in Dollar Cents etc. - in such a case you need to convert the EPS into the £ Sterling equivalent).

You will find that various Websites like ADVFN.com and MoneyAM.com etc. and things like ShareScope and Stockopedia have published P/E Ratios - I NEVER use these and I always go back to Raw Numbers and work out the P/E Ratios for myself (I even do this quickly in my head sometimes if I am having a cursory initial look at a stock). This is crucial in several ways:

• The published P/E Ratios are nearly always Historic. This is not a huge amount of use for me - I want the Forward P/E.
• These numbers are prone to errors caused by Adjustments in the Accounts etc. - working them out yourself from the Raw Data negates such issues.
• There are often huge differences between the Historic P/Es and the Forward P/Es - for instance, a Company might have a Historic P/E of 38 (which would be extremely high, as I will explain in Part 2) but a more Reasonable Forward P/E of 12. This could be caused by a One-off shock to Earnings last year or perhaps the Company has done an Acquisition which is strongly Earnings enhancing. Remember, the Past is the Past - it is the Future we are interested in (I intend to write a Blog about the whole subject of Focusing on the Future at some point but I suspect that is many, many, months away.)
• When calculating the P/E Ratio is it valid and Best Practice to strip out any Cash Pile that the Company holds. For instance, a Stock might have a Published P/E of 28 but once you strip out a Cash Pile, they might only be on a P/E of 9. I see this kind of thing a lot - current examples are 32Red TTR and Moss Brothers MOSB. These High (but ultimately false) P/Es can lead you to overlook excellent Investments. When calculating the P/E Ratio from the Share Price and the EPS, you will need to convert the Cash Pile into Share Price terms and subtract it from the Share Price. For example, a Company might have a Market Cap of £100m and a Share Price of 230p and a Cash Pile of £20m. In this case you would calculate the Cash Pile to be worth about one-fifth of the Share Price and consequently reduce it by about 46p and do your P/E Calculation using an Adjusted Share Price of 184p.
• When calculating a Forward P/E using the Raw Data, you might have a look at the Forecast EPS and it could strike you that the Analysts have understated or overstated the likely Earnings. On this basis, you can adjust up or down the EPS figure to give you a more realistic P/E and an improved ‘Margin of Safety’. Published P/Es do not enable you to do such sophisticated (and essential) stuff.
• You should find that as you go out into the Future working out Forward P/E Ratios, the number should drop as the EPS rises (obviously) - if it doesn’t then clearly you have screwed your Maths up or the Future Earnings are expected to fall (not good) or perhaps your Calculator is broken. You also need to be careful to understand the Forecast Figures - are they ‘Adjusted’ in any way?

For examples of how I use P/E Ratios in practice and some example Calculations, you can pretty much go to any of my ‘Stock Buy Rationale’ Blogs and scroll down to the ‘Valuation’ section where it should all be. The recent NPT, UTW and QP. ones are good examples but all my Buy Blogs include this information because it is so critical to any Investment I make.

OK, that’s it for now - this is a very important and difficult subject - but if you can grasp it then I suspect it will have a marked effect on your Investing success and importantly on your Confidence as an effective and efficient Investor. I recommend you read this a few times and fully take it on board - in the next part, I will discuss at length how to Interpret the P/E Ratios in a variety of different scenarios and with several examples.

Cheers, WD.