Trading with regard to P/E Ratios
As I mentioned earlier in the Blog Series, I ideally want to be buying Stocks which are Priced in the Market on a Forward P/E that I think is lower than what it really should be and where the Market has misunderstood a Growth Story or perhaps Oversold a Stock with Problems and not given the appropriate ‘Value’ in terms of P/E Ratio - often with the latter a Company has been in trouble but is in the early stages of a Recovery and the Market has not yet woken up to the improvements. Another great example comes about from IPOs (Initial Public Offerings) - I quite often find that Stocks that are new to the Market are on a lower P/E than they should be - and this creates a wonderful opportunity as the Market wakes up to the Story and gets to know the Stock - I want to be in before the Herd (I have written about this recently in a separate IPOs Blog - I will put a link at the end of this Blog Series).
Therefore, once I have bought my Stock on its wonderfully low and undervalued P/E, I need to monitor progress and constantly re-evaluate its Value in terms of the P/E (and other things) and if I see the P/E starting to get very high, then it might be time to Topslice or even sell the whole lot of my Holding. These days I am much more likely to hold onto a Stock that has done very well and try to ‘Run the Profits’ for as long as I can - but if things look stretched, I will usually Topslice a bit off. As I mentioned earlier, once a Stock gets on a Forward P/E up around 20 or more, then I will be considering Selling at least some or all of the Holding - and of course it is important to strip out any Cash from the Calculation. To justify a Forward P/E of 20 or more, you really have to have a very special Stock and ideally it should have a fast and reliable Growth Rate of Profits perhaps around 15% a year at least. As an alternative to straight out Selling, it might be an idea to think about using a Trailing Stoploss of perhaps 10% or something - in other words, if the Stocks falls 10% from the Peak, then your Position gets automatically Sold (you can of course make this a Manual thing rather than having an Agreed and Set Stoploss Level with your Broker).
As I have mentioned earlier in this Blog Series, if a Stock can re-rate from a low P/E to a high one, then you can benefit from a ‘Double Whammy’ as Earnings rise at the same time. However, once the Re-rate has happened, you then might have a Stock on a Forward P/E of 20 or more and be very tempted to sell - but it is worth appreciating that sometimes a Stock can be on a Silly P/E and if it can beat Earnings Forecasts, then it can in effect ‘Grow’ into the high P/E Rating - I know this is something that the Legendary Cockney Rebel (@RebelHQ on tweets) often talks about.
Loss Making Companies
For starters, why are you even considering a Company that doesn’t make money? (WheelieSlap on the wrist for you).
In general terms I very rarely invest in something Loss making and if I do, then it would only be a tiny Position and I would want a clear and highly probable route through to Breakeven and Profitability. As an example, I hold Accsys Technologies AXS at the moment but I only have 0.5% of my Portfolio in it and it really is a special case. If you want to read about it, then I will put a link at the end of this Blog Series to a Blog I did on AXS ages ago (if you are impatient, you can find it under the ‘Stock Buy Rationale’ Category or look at the ‘Blog Index List‘ at the bottom of the ‘Useful Links’ page which will give you the date it was penned).
The simple and unpalatable truth is that very few Listed Loss Making Companies ever make it and turn into wonderful Profit Generators making their Shareholders £squillions. It just doesn’t happen. Wise up and stop dreaming. Loss Making Junk is for Shrewd Traders - not Investors.
As I mentioned above, all you can do is make (hopefully) educated guesses about the likely path in future Years to Revenues and Profits and try to value the company on that basis. Look a couple of Years into the Future and try to figure out what the likely Earnings Per Share will be - then try to work out a Forward P/E Ratio based on this - but to give a Margin of Safety then really you probably want a P/E below perhaps 20 or so - anything higher and you are overpaying.
I hate this Loss Making Crud. Whenever I see a Results Statement from one of these stinky AIM dogs, I go straight to the Cash Pile and the Reported Loss (in effect the Cash Burn) and quickly work out how long it will be before they need more Capital via a Placing or Rights Issue - quite frankly these things are a joke and if the Company was any good you would not have the chance to buy into it - Private Equity would own it, not you. You are being milked to fund their experiment and be in no doubt that if it is a success, the Insiders and Major City Investors will be getting the benefit.
In extremely rare cases you do get the odd Biotech or Pharma Stock where the Earnings can rise exponentially if they manage to get all the right Approvals and successfully launch a new Product - but these Stocks are EXTREMELY UNUSUAL and you will waste a fortune even trying to find them. Do yourself a favour and go and buy a Lottery ticket.
“It is Human Psychology to Overpay for Long Shots when backing Favourites would pay better.” (I think Chris Dillow from Investors Chronicle said that.)
Other uses for P/E Ratios
The P/E is actually rather clever - you can use it to value anything. For instance, if you look at a UK Government 10 Year Gilt (Bond) yielding 0.68% (this is the figure from last weeks Investors Chronicle), then the P/E Ratio is 147 (100p divided by 0.68p) - anyone still think Government Bonds are good value?
You could apply it to a House. Say it cost £250,000 to Buy and gave a Rental Income of £1000 a month (let’s ignore all Costs and Mortgage Interest etc.), then the P/E Ratio would be 20.8 (£250,000 divided by £12,000). Obviously this is a high figure and of course once you throw in Maintenance Costs and Mortgage Servicing etc., it starts to look much less appealing as the P/E will rise. OK, it is simplistic but hopefully you get the point.
A very valuable use of the Historic P/E Ratio (I am not sure if Forward ones are available - they probably are somewhere) is to get a measure of how Global Stockmarket Indexes are Valued. In the first few pages of Investors Chronicle there is always a table with the current Historic P/E Values in it for all the Indexes - I find this very useful for getting a sense of how the valuations stack up. At the moment, I think very few (if any) Global Indexes could be called Good Value - I think most are well overvalued. As with Stocks, if and Index is up around a Historic P/E of 20 or more, then I get worried - currently most Major Indexes are higher than this and the Nasdaq is really high (although to be fair the high-growth nature of Tech stuff should allow a slightly higher P/E of maybe 25 - 30 or so - it is currently around 38 !!)
Earnings Yield - Inverse P/E Ratio
This is something that I suspect very few people know about - even experienced Investors may not have come across this much - and I doubt many People use it with their Day to Day investing. Mind you, having said that, I know the Legendary Richard Beddard on www.iii.co.uk (@RichardBeddard on tweets) uses the concept of ‘Earnings Yield’ all the time in his columns.
The Earnings Yield is sort of similar conceptually to a Dividend Yield - in effect you are expressing the Percentage of Earnings that the Company generates for a given Share Price - and like with a Dividend Yield, the higher the % the better (ok, ok, we all know there are many nuances around such a sweeping generalisation but let’s keep it simplistic for now). The easiest way to calculate the Earnings Yield is to see it as an ‘Inverse P/E’ - so if you have a Forward P/E of 12 for example, then the Earnings Yield will be 8.3% (you calculate this by dividing 100 by 12, which equals 8.3%).
You can also Calculate the Earnings Yield by dividing the Earnings Per Share by the Share Price and multiplying by 100%. So, if the Forward EPS is 15p and the Share Price is 238p, then the Earnings Yield will be 15p / 238p x 100 = 6.3% (I did that in about a millisecond in my head*, but you can go and grab your ancient Casio Pocket Calculator and work it out yourself - an Abacus is a possible alternative or a SlideRule if that’s more your ‘Old Skool’ weapon of choice).
“Ok Wheelie, we get that, what’s the ‘kin point of it?”
Alright, Alright, I’ll come clean - the Earnings Yield is a pretty little thing but I can’t say that I use it everyday. However, there is a very interesting use for it at the moment - let me show you……
The latest Copy of Investors Chronicle (it is so fresh, I had to rip that irritating plastic cover off it and throw away the inevitable Flyer that gets shoved in with it, without even looking at it) on the ‘Markets this Week’ page has the FTSE100 on a Historic P/E of 39.9 and a Historic Dividend Yield of 3.71%. So, using the Inverse P/E Calculation, this gives an Earnings Yield of 2.5% (100 divided by 39.9). Now, sharp eyes and engaged Slow Brains will notice something strange here - last year (this is ‘Historic’ remember and the Forward situation might be different), the Earnings Yield was 2.5% but the FTSE100 Companies collectively had a Dividend Yield of 3.71%; at first glance, this implies that FTSE100 Companies collectively paid out more in Dividends than they were generating in Earnings.
Imagine if this was one individual Company - it would mean that the Company was paying out more than it earns and must have been digging into Cash Reserves and/or going deeper into Debt - neither of these situations would be sustainable for long. In addition, any Business must retain some Earnings for Investment Purposes in the future - so if you have a Dividend Yield of say 4%, you probably need at least 6% of Earnings Yield so that there are some Earnings retained for Investing in new Products, or doing Bolt-on Acquisitions or expanding Factories etc.
OK, my ‘analysis’ of the FTSE100 is very simplistic for the reasons I will come onto in a bit - however, I hope it gets the point across and Readers can get an understanding of how useful the Earnings Yield concept is for thinking about how much Dividend a Company pays out and how much Earnings it retains etc. It comes back to something I bang on and on about - if you buy a Stock on a High P/E Ratio, then you are getting much less Earnings Yield - which means less for Dividends for you and less for Reinvestment. For example, a Stock on a forward P/E of 22 will have an Earnings Yield of just 4.5% which does not leave much to pay you a decent Divvy and to Invest in growth - and remember, you are paying a Forward P/E of 22 because you think it is a Growth Company - it might not be a good Growth Company though simply because it is unable to invest enough.
My Analysis of the FTSE100 Earnings Yield is simplistic because of the following reasons and probably a few more that I have not listed !!:
Across the Cycle P/E Ratio
This is something I have never used myself (to be honest I have never felt the need and I think just using the Forward P/E Ratio with sensible adjustments to the Forecast EPS where necessary is simple and does the job well enough), but I can understand why people may want to use it. The problem with using a Historic P/E or a Forward P/E for 1 year or so is that they are quite Short Term ways of valuing a Company and take little appreciation of Longer Term Value and how Earnings can fluctuate across the Business Cycle over perhaps 5 years or so.
There are probably other ways to calculate this and Readers can do some research into these if they so wish, but a simplistic way I can come up with is just to ‘normalise’ the Earnings over a given Period. For instance, you could take the Earnings per Share for the Company that have been generated historically over the last 5 years and then add them together and divide by 5 to get an ’Historic Average EPS’ for the period. You then would calculate the P/E Ratio in the normal way (Share Price divided by your new Average EPS figure) and you would then need to decide if the figure you come up with represents decent Value. Without a context to put this in, I suspect you would need to look at other Stocks in the same Sector and do a comparison.
You could of course vary things a bit. Perhaps you could use more years - if you have the data, you could go up to 10 years or something (although there is a big risk that the Company will have changed so much over that time, due to Acquisitions or changes of Directors or suchlike, that the Numbers generated by your Analysis are pretty meaningless) or perhaps you could do 3 Historic Years of Earnings and 2 Forecast Years of Earnings - hopefully that gives you some idea of the possibilities. I am clearly no expert on this, but maybe there is some way you can incorporate an element of Growth into your Calculations - there of course is a risk that it all gets too complicated though and is of little practical value.
Remember, it is critical to keep it REAL.
The most common ‘tool’ with regards to the Cyclical P/E is the Robert Shiller ‘CAPE’ ratio - you can read more here:
That’s it for Part 3 - you may have noticed this has grown into 4 Parts and in the next bit I look at some other ways to Value Stocks apart from the P/E.
PS, I have been topping and tailing this Blog to the wonderful voice of Karen Carpenter. I was watching some silly Channel5 nonsense the other day called ‘The Nation’s Bestest most Favouritieist Carpenters Song’ and it struck me that although I know all the ‘hits’ and regularly hear them, there is a massive catalogue of Album Tracks that I have never heard. Then, as if by some miraculous coincidence, I popped into the local Charity Shop to grab some Books and there was what I think is the first Album they did (and only a quid !!) - OK, it’s very MOR and a bit twee but the Voice and Harmonies are just surreal. A true Legend. RIP girl.
*er, no I didn’t. I have a brand spanking new ‘Texet’ Solar Powered Calculator from Rymans - £3.99 -bargain.
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