Valuation, Valuation, Valuation - Bursting for a P/E - Part 2 of 3

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Part 1 of this Blog Series was scribbled about a week ago - I recommend reading that and understanding it before trying to get your head around this one - it’s an extremely important topic but not particularly easy to get a grip of.

How to Interpret the P/E Ratio
Right, now we have got to the critical bit. Calculating a P/E Ratio (remember, I prefer the Forward P/E Ratio) is one thing, but it is not much use if you have no framework and knowledge to put that Number into context. The following list should help with that interpretation (well, that‘s the plan anyway - you may need to read it a few times and perhaps makes notes - this is extremely important):

• Years to earn back your Investment - The simplest way of understanding a P/E Ratio is to think of it as the Number of Years that it will take for Earnings of the Company to earn back the Money you have invested in the Shares. For example, on a P/E of 6, it will take 6 years for you in effect to get your Money back, whereas on a P/E of 42, it will take 42 years to earn your Money back. This is a very simplistic view and in reality you need to consider Growth Rates as I will come onto in a bit - however, to justify a P/E of 42 you need an extremely fast Profits Growth Rate like 30% or more per year - this is often very difficult to sustain for long periods. Obviously the quicker the payback the better - but of course there are a lot of complexities and nuances around this - as you will see as we go through the list. 
  
• Starting off in very simple terms - a P/E of 20 or more is High (could be overvalued/expensive) and a P/E of 10 or less is Low (could be undervalued/cheap).
  
• Cheap or Expensive? - It is important to understand that when a Stock is referred to as ‘Expensive’ it means it is on a High P/E Ratio (sometimes this will be referred to as a ‘High Rating’), it does not refer to the Share Price - e.g. a Stock is not ‘Cheap’ at 8p but ‘Expensive’ at 4850p (if is very possible that the 8p Stock is Mining Junk worth pretty much Zero but the 4850p Stock is a high quality growth Stock worth considerably more). If a Stock is said to be ‘Cheap’, then it means it is on a Low P/E. 
  
• The Double Whammy - A Stock on a Low Rating can be ‘Re-rated’ to trade on a High P/E as the Share Price rises as Investors and Traders buy into the Stock (this is sometimes referred to as ‘P/E Expansion’). As an example, this is precisely what I would like to happen on Utilitywise UTW - as the Company rebuilds Market trust, I hope to see the Earnings rise and the P/E multiple to rise - this gives a lovely ‘double whammy’ and this is how serious money is made. If you can get fast EPS growth combined with P/E expansion it is simple Maths that drives the Share Price up often to many multiples of your Buy Price (this is one very good reason why you do not need to buy High Risk AIM Crud to get multi-baggers). This is why I like to buy Companies on Low P/E Ratings - if you buy them when the P/E is up around 18 or so already, then you do not get the P/E Multiple Expansion - so your Returns will be more pedestrian and just rise with the Earnings Growth Rate (although a Quality Stock on a reasonably High P/E, less than 20 ideally, can still do very well). BOO is an example where I was extremely fortunate to buy into a Growth Stock with rising EPS which then has had a huge Re-rating of the P/E multiple at the same time - in this case it has been a Triple Whammy for me !!
  
• Growth Rate - An obsession of mine is to relate the P/E Ratio to the Profit Growth of the Stock - and I think this is an extremely useful Framework for thinking about P/E Ratios for a given Stock. The important technique I use here to measure any Stock is that when I figure out the P/E Ratio, I want the Yearly Growth Rate of Profits to be about the same. For example, if a Stock has a P/E of 12 then I want the Yearly Profits Growth Rate to be 12% or more BUT NOT HUGELY LOWER. Ideally, for a Stock on a P/E of 12, I would love the Growth Rate to be perhaps 15% a Year and I would like to not only see this in the Forecast EPS figures for the next couple of years but I would also like to see a similar Track Record of Growth over many years. 
  
• PEG Ratio - To help us with this Analysis, there is the useful Ratio of the PEG (the Price Earnings / Growth Ratio). To work this out, you divide the P/E Ratio by the Yearly Growth Rate of Profits - again I would do this from the Raw Data and use the Forward P/E and for the Growth Rate I would probably use an Average Figure which reflects the Future Earnings Growth expected and the Historic Growth Numbers achieved. The PEG is wonderful because if you get a figure of 1 or below, then the Stock could be really Cheap and if you get a high figure like 3.4 or something, then the Stock could be Expensive - for example, on the latter you could be paying a P/E of 34 for a Stock with a Profits Growth Rate of 10% a year. You need to be careful with the PEG Ratio though and bear in mind lots of the other factors I discuss below. A famous exponent of the PEG Ratio is Jim Slater - I think his book ‘The Zulu Principle’ can be found in Wheelie’s Bookshop and is well worth reading.
  
• Avoid buying trouble - Sadly life is not as simple as Buying Stocks on a P/E of 6 or below and Selling Stocks when they are on a P/E of 20 or more - there are many nuances - and this is what I meant earlier about being able to fully understand these concepts and really getting your head around what P/Es truly mean and how they can help you find ‘Cheap’ and ‘Expensive’ Stocks. A Stock on a Low P/E could genuinely be Cheap - for instance, I recently Blogged about Utilitywise UTW and that is on a Forward P/E something like 6 - and in this case I think that is signalling a bargain. However, a Low P/E like this can often mean the Market is telling you there are serious problems and you could be buying Trouble. In such a case, the Share Price might have been driven down because Investors and Traders think there is a very high risk of the Stock going Bust or perhaps just coming out with Profit Warnings in the future or just continually reporting declining Profits - none of these things are good. The Worst Case Scenario can be when a Company has a Big Debt Pile and perhaps a Huge Pension Deficit as well (and maybe some Court Case Liabilities or something - for example BP.) - with such Company Weakness, a Low P/E could be telling you that this Company is likely to go bust and it is best avoided or slightly better there might be a Rights Issue or Placing (with the latter only Institutions can get the new cheaper Shares - but both mean dilution of existing Shareholders as new Shares are issued). 
  
• The Beauty of Cash Piles - On the flipside, you do sometimes get anomalies where a Company has a big Cash Pile and when you strip out the Cash from your P/E Calculation, you get a low P/E like 7 or something. This is currently the case with 32Red TTR and Netplay NPT I think - both look very cheap and the Cash Piles mean they are extremely unlikely to go bust - the Cash gives them options as well as a time cushion to sort themselves out if they have had Trading Issues. I love these kind of undervalued, Cash rich, Stocks - they usually work out very well for me.
  
• Quality Established Companies - with long Track Records and servicing reliable, predictable and defensive markets, can often justify a High P/E Ratio. This is especially the case at the moment where Low Central Bank Interest Rates, NIRP (Negative Interest Rate Policy) and QE (Quantitative Easing - 21st Century Money Printing) have helped to drive down Yields across most Assets and have driven Investors up the Risk Curve away from ‘Safe’ stuff like Government Bonds and into higher Risk stuff like Stocks. As a result, Stocks like Diageo DGE, Unilever ULVR, British American Tobacco BATS, Dignity DTY are trading on High P/Es over 20 or so - this is high by their Historical standards and is hugely driven by the ‘Hunt for Yield’ and of course the devaluation of Sterling. Of course the catch is that the Dividend Yields are nowhere near as attractive as they were because the Share Prices have risen a lot. However, we need to be careful here - I see many ‘Experts’ saying that High Valuations are justified because Interest Rates are so low - to me that is very much like “This time it’s different…..” and we need to keep in mind that it never is different and Valuations matter….
  
• Fast Growth is difficult to sustain - Very few Companies can grow at High Growth Rates like 15% + per year for long periods and higher Growth Rates are even tougher - there are exceptions, but they are extremely rare and probably in the Tech Sector where of course new developments can wipe out their Market in a very short space of time. Related to this, I often see Companies with High Growth Rates in Profits but where Revenue Growth is pedestrian (2 or 3% perhaps) or even in decline. Obviously this cannot be sustained long term and Revenue Growth is the lifeblood of any business over time. Examples of such decliners are Trinity Mirror TNI, and the old WHSmith which did this for years under Kate Swann with lots of cost cutting. Royal Mail RMG is doing a similar thing but it has so much inefficiency that it can probably do it for many years to come !! Obviously such Stocks should never be on High P/E Ratios unless they can suddenly get some proper Revenue Growth - a P/E under 15 is probably about right, assuming there is a decent 3 to 5% Dividend Yield as well.
  
• If a Company has a very large Debt Pile - then it should have a lower P/E Ratio (anything more than 3 times Annual Profits would get me concerned - although in reality I rarely buy any Stock unless it has just a tiny bit of Debt - and in recent years I am more and more wanting my Stocks, especially smaller Companies, to have Cash Piles and no Debt), As discussed in one of the Bullet Points above, a highly indebted Company has a big risk of going Bust and this must always be considered and evaluated. However, if you find a Company that has perhaps Debt that is 6 times its Annual Profit, and if you decide that the Debt Dynamics (in other words, how the Debt moves over time and under various scenarios) are favourable and the Company can survive, you need to give it a lower P/E Ratio to allow for that Debt Risk and the burden of even Servicing that Debt Pile (i.e. paying the Interest Payments and meeting Bond repayment dates). As an example, Premier Foods PFD many years ago had the most ridiculous Debt Pile imaginable - certainly more than 6 times Profit and there must have been serious doubts over whether or not the Company would survive (in fact, had we been in more ‘Normal‘ Interest Rate times, it is hard to see how it would have made it - I suspect only the extremely low Interest Rates since 2008 saved it from going under). What PFD did have however (apart from some decent new Management obviously) were some truly iconic and established Food Brands like Marmite, Mr Kipling, Ambrosia (I might be wrong on the last one but you get the picture) and they sold some Brands off and invested in the good ones etc. and managed to turn things around. In the Bad Times PFD was on a Forward P/E of perhaps 5 or something - apparently very low but it had to be due to the Debt. As time went by the P/E Ratio has risen which is as it should be. For me the Risk was too great - even though it looked cheap, I had no interest in buying (if you are ever tempted to buy such a Situation, it might be worth using a Stoploss or at least just buying a Small Position). However, about 6 months ago I noticed it was starting to look good and I remember discussing it on Twitter and stuff and it has risen strongly since then. Of course I didn’t buy it ……..typical. I do however hold The AA (AA.) which does have a big Debt Pile and in a similar way to PFD the Revenues and Cashflow are very reliable and stable (and the AA Brand is superb) but the Debt is coming down with some Divisions being sold and over time I expect it to be re-rated with a higher P/E - and this will be helped by the Brand Extension Strategies of moving back into Financial Services like in the past - in the mean time, I am picking up a reasonable Divvy with I think is 3% or more.
  
• Cyclical Stocks should never be on a high P/E - A great example here is Housebuilders before the 2008 Credit Crunch Crash - most of these were trading on Forward P/Es of maybe 6 or 7 - that probably seems very low to Readers now - but that is how it was and in reality the Market had got it dead right. I know Housebuilders have been de-rated a lot around the Brexit Vote but they are still on much higher P/Es than they have been many times historically. Perhaps they are better in many ways today than they were in the past, but even so I would find a Forward P/E much more than 15 as very expensive. This same lower P/E rule should apply to anything Cyclical (Sales tend to rise and fall with the general state of the Economy - in Recessions they get spanked) - for example stuff like the Brickmakers, Banks, Car Retailers, Manufacturing Companies dependent upon the Economy (most of them), Recruiters, Marketing Companies, Equipment Rental Firms, etc. etc. Really none of these kinds of Stocks should be on Forward P/Es higher than 15 or perhaps at an absolute stretch 18 if debt is low (a good Balance Sheet). Remember these are Maximum P/E levels - if I was buying, I would want to pay a P/E perhaps around 10 or maybe 12 and my Profit would partly be made by the Re-rating if the Company does well as I probably expect it will do (that’s why I would be buying it !!). I suspect we are in a situation today where many Cyclicals are on P/Es right at the top end of my range and there is very little upside for Buyers now - when you are buying into any Stock you need to buy at a Price where other People will be happy to come in after you and buy it also - because you need them to push the Price up for you. If you buy at the Top, then there will be no one after you to buy into it.
  
• Miners and Oil Companies are a sort of special kind of Cyclical Stock - Miners especially tend to be very Cyclical and Valuing these things is extremely difficult. In many ways it almost seems like a waste of time trying - their Earnings are so unpredictable and variable depending on the underlying Commodity Prices and perhaps just buying or selling them according to their Charts (buy Uptrends near the start) is the way to go. If you must try and apply a Forward P/E, then maybe you should never go for more than 15. The Dividend Yield and how sustainable you think it might be is probably a reasonable way to ‘value’ them - but it’s really not easy. More and more I think the way to play Miners is just to buy an Investment Trust like City Natural Resources CYN or Blackrock World Mining BRWM when you think the time is right according largely to what the Commodity Charts are telling you. Individual Miners with individual Mines are just so prone to Disasters and problems such as Warzones, Accidents, etc. that it makes little sense to buy just the one Stock - a collective Basket of Stocks in a Fund makes a lot more sense and is far lower Risk.
  
• US Tech Stocks - many of these Stockmarket Darlings look hugely overvalued to me. The usual suspects, the FANG (Farcebook, Apple, Netflix, Google) Stocks look quite silly on P/Es up nearing 100 or so although Apple AAPL looks pretty good down on an Ex-Cash Forward P/E around 8. Many US Technology Stocks and Biotech Stocks are on ridiculous Valuations - some I have seen up near 200 - it is absurd and very dangerous. Much care needs to be taken here - I am Short Tesla TSLA and that thing doesn’t even make any Earnings to base your P/E multiple upon !! Pure insanity. I hold PayPal and even that is on a high Forward P/E up around 26 but it is cheap by US Standards and of course part of any Valuation is relative to other Stocks - but we must keep our heads and not get carried away with the Euphoria when the Market goes collectively nuts.
  
• Compare within a Sector - a very useful technique is to look at a particular Stock and line it up against other similar Stocks in the same Sector and try to see how the P/E Ratios compare. For instance, if you looked at Housebuilders, you might find one on a Forward P/E of 7 whereas most of the others were on a Forward P/E around 11 to 13 - so the first one might be very cheap. However, of course you need to analyse the situation carefully because there might be a very good reason for the Low P/E in this case - perhaps it has high debt levels or faces Litigation or operates in a different Sub-sector or something - but you might have found a genuine Bargain.
  
• Careful Stockpicking and Buying at Low P/Es - Obviously everything I have written here is very much on the assumption that you pick Quality Stocks and they deliver the Earnings as we expect - if they fail to meet Expectations, then the EPS will not grow anything like as fast and the P/E Ratio can Re-rate DOWNWARDS - this is why it is so critical to Buy Stocks on cheap or at least fair P/E Ratios and to put a lot of effort into trying to buy Shares in Companies with a good record of delivering what they say they will (or better !!). There is even a piece of Stockmarket Folklore going around which says that if the Dividend Yield is higher than the P/E Ratio, then you could be buying trouble (but of course, you could actually have stumbled upon an incredible Bargain).
  

I warned you that was a tough but critical set of Bullet Points. In Part 3 of the Blog Series I will look at some other simple methods to value things and how you can use P/E Ratios in a practical day to day Trading sense.

Right, you better stretch your legs and get a brew and read it again because there is a small chance it will make a bit more sense if you read it again !!

Cheers, WD.