The lowest PE stocks are not always the most attractive
By Anton Tagliaferro and Michael O’Neill | 26 October 2018
IML’s philosophy has always been to buy stocks with competitive advantage, recurring earnings, capable management at a reasonable price.
There are several methods that can be used by investors to assess the attractiveness a company’s share price. The most common methodology, often quoted by brokers and market participants, is the price earnings ratio – known as the PE ratio.
The PE ratio of a company is calculated by dividing the share price of the company by its earnings per share. The PE ratio is often used as a measure of assessing whether a company is ‘cheap’ or not. A simplistic view is that a lower PE stock is cheap while a higher PE is assessed as expensive.
In this week’s lesson we will discuss the reasons why the simplistic view of looking at stocks trading at the lowest price earnings ratios (PE) is not always the best approach for determining good value.
So how does a PE ratio work?
In a nutshell a PE ratio gives a measure of how many years earnings are captured in a company’s share price.
Using a simple example, if company’s A’s shares are trading on the stockmarket at $10 and its forecast earnings per share is $1 per share, then the PE ratio of that company is said to be 10. In other words, by buying the shares at $10, an investor is paying the equivalent of 10 times the yearly forecast earnings for that company.
On the other hand, if company B’s share price is trading at $40 and its forecast earnings per share is $2 a share, then the PE of company B is 20 times yearly earnings.
At 20 x earnings, Company B’s shares are trading at a much higher PE than company A – and thus company B’s shares at face value look much more expensive than company A’s shares, which trades on 10 x earnings.
So what is the right price to pay for a stock if one is using a PE ratio to assess a company’s attractiveness?
In the example above, given that Company A is cheaper than Company B – does this mean that investors looking for value on the sharemarket should always buy Company A before Company B?
The answer is not necessarily. One has to consider many other qualitative aspects of a company, some of the most important of which are listed below:
Growth rates – companies growing at a faster rate can represent better value even though they are trading at a higher PE ratio. In the example given earlier, even though Company B’s shares are trading on 20 x earnings compared to company A’s on 10 x, if company B’s earnings are forecast to grow its earnings at a much faster pace than company A then Company B may actually turn out to be the better buy.
For example, for most of the last ten years Sonic Healthcare, Australia’s largest pathology provider, have always traded at a higher PE (and hence were more expensive) than Boral, which generally traded on a lower PE. As shown in the chart below, despite looking more expensive, Sonic’s shares have been a far better performer over the long term because Sonic’s earnings have grown at a much faster pace than Boral’s.
Chart: value of $1000 invested in Sonic Healthcare vs Boral
Source: Morningstar Direct; 1/09/2008-30/09/2018
Balance sheet strength – focusing on the PE of a company to assess whether a company’s shares represents good value or not completely ignores the balance sheet strengths of a company.
The higher a company’s debt the riskier the company and as a result it should trade on a lower PE than a company in the same sector that has less debt.
The Star Entertainment Group which operates casinos in Sydney, Gold Coast and Brisbane trades on a PE ratio of 17 x expected 2019 earnings while casino operator Crown Resorts which operates the Melbourne and Perth casinos trades on a PE of 20 x expected 2019 earnings.
On face value is Star a better buy than Crown? because when comparing the expected 2019 PE to Crown, Star appears much cheaper on a PE basis.
However, this simple PE comparison ignores the fact that Crown has zero debt and holds over $300m in cash on its balance sheet while Star has around $800m of net debt.
In other words, even though Crown trades at a higher PE than Star, this is justified because of the healthier balance sheet managed by Crown.
Investing in the future – simply just focusing on the PE of any company ignores what a company is spending today that should lead to growth in earnings and dividends in future years.
In the example of The Star and Crown Resorts, once again simply comparing these companies’ 2019 PE’s to decide which company’s shares offer better value ignores the fact that Crown is currently in the process of constructing its new Barangaroo casino in Sydney, which is expected to open in 2021. Barangaroo is expected to contribute significantly to Crown’s earnings. Ironically this will likely detrimentally impact The Star’s Sydney casino earnings from 2021 onwards.
In fact, in IML’s view, adjusting for the above factors and valuing Crown by adding a sum of all the parts (which we will discuss in Lesson 12 next week), Crown represents better long-term value than Star. The PE comparison of the two companies does not capture the strength of Crown’s currently cashed up balance sheet and better growth prospects in the long term thanks to its investment in Barangaroo.
Composition of reported earnings – a PE comparison also ignores issues such as the accounting treatment of items like Research and Development (R&D), whether IT expenses are capitalised or written-off and how individual companies account for one off type expenses.
This is best explained through an example: If we go back to 2007 and look at two Healthcare companies that had both performed strongly up to that point thanks to seemingly good earnings growth in the preceding 5 years. In 2007, CSL traded on a PE of 26x earnings while Primary Healthcare (PRY) traded on around 24x earnings.
Based only on their respective PE ratios, PRY looked slightly cheaper than CSL. However, this analysis ignored the significant differences in accounting policies utilised by each company as well other factors which enhanced the quality of CSL’s earnings relative to PRY.
In particular, CSL has always implemented a conservative accounting policy where all research and development costs are expensed. This means that CSL’s earnings are quite understated because of this conservative write down of R&D, which means that CSL’s stated PE looks higher than it should be if some of the R&D was capitalised. As a result of this ultra conservative accounting treatment, all the intellectual property and patents generated from this expenditure do not appear on CSL’s balance sheet.
By contrast, PRY’s reported earnings at the time did not capture payments made to acquire doctor practices which were capitalised rather than amortised through the income statement. In 2015, PRY eventually changed the recognition of these payments which caused a restatement of past earnings, resulting in historical earnings per share being restated and falling almost 30%. This meant that PRY’s reported PE of 25x was actually closer to 35x once this accounting adjustment was made.
Conclusion: When looking to buy companies at a reasonable price, looking at PE ratios can be a useful tool when comparing the relative attractiveness of different companies shares prices. However, an investor also has to look beyond a simple PE comparison to assess which companies offer the best value in the sharemarket and take into account other factors such as each company’s earnings growth prospects and balance sheet.
While the information contained in this article has been prepared with all reasonable care, Investors Mutual Limited (AFSL 229988) accepts no responsibility or liability for any errors, omissions or misstatements however caused. This information is not personal advice. This advice is general in nature and has been prepared without taking account of your objectives, financial situation or needs. The fact that shares in a particular company may have been mentioned should not be interpreted as a recommendation to buy, sell or hold that stock.