Saturday, June 14

Earnings-Based Equity Valuations

Earnings-Based Valuations
Earnings Per Share and the P/E Ratio

The most common way to value a company is to use its earnings. Earnings, also called net income or net profit, is the money that is left over after a company pays all of its bills. To allow for efficient comparisons, most people who look at earnings measure them according to earnings per share (EPS).
You arrive at the earnings per share by simply dividing the rupee amount of the earnings a company reports by the number of shares it currently has outstanding. Thus, if ABC Ltd. has one million shares outstanding and has earned one million rupees in the past 12 months, it has a trailing EPS of Rs.1.00. (The reason it is called a trailing EPS is because it looks at the last four quarters reported -- the quarters that trail behind the most recent quarter reported).

Rs. 1,000,000 / 1,000,000 shares = Rs.1.00 in earnings per share (EPS)

The earnings per share alone means absolutely nothing, though. To look at a company's earnings relative to its price, most investors employ the price/earnings (P/E) ratio. The P/E ratio takes the stock price and divides it by the last four quarters' worth of earnings. For instance, if, in our example above, ABC Ltd. was currently trading at Rs.15 a share, it would have a P/E of 15.

(Rs.15 share price) / (Rs.1.00 in trailing EPS) = 15 P/E

Also called a "multiple", the P/E is most often used in comparison with the current rate of growth in earnings per share. We assume that for a growth company, in a fairly valued situation the price/earnings ratio is about equal to the rate of EPS growth.
In our example of ABC Ltd., for instance, we find out that ABC Ltd. grew its earnings per share at a 13% over the past year, suggesting that at a P/E of 15 the company is pretty fairly valued. We believe that P/E only makes sense for growth companies relative to the earnings growth. If a company has lost money in the past year or has suffered a decrease in earnings per share over the past twelve months, the P/E becomes less useful than other valuation methods. In the end, P/E has to be viewed in the context of growth and cannot be simply isolated without taking on some significant potential for error.
Ever wonder why the price/earnings ratio has become such an important parameter for investors? Sure, you may use it all of the time, but why is this even relevant? Why not the price/inventories ratio? Or the price/depreciation ratio? Both of those are concrete financial factors that almost every business can report. The reason is that the price/earnings ratio tells you how many years it will take at the current rate of earnings for you to make all of your money back. Nothing more, nothing less. If a company has a price/earnings ratio of 10, that means if the earnings stay constant you will make back in earnings the money paid to buy the stock in 10 years. This also translates to a yield of 10% (100/10). The price/earnings ratio is ubiquitous because it uses the same inescapable logic that any actual acquirer would apply to a business being acquired: How long will it take to make my money back? What is the current value being placed on the future earnings power of this company?

Are Low P/E Stocks Really a Bargain?
There is a large population of individual investors who stop their entire analysis of a company after they figure out the trailing P/E ratio. With no regard to any other form of valuation, this group of investors blindly plunge ahead armed with this one ratio, purposefully ignoring the vagaries of equity analysis.
Popularized by Ben Graham (who used a number of other techniques as well as low P/E to isolate value), the P/E has been oversimplified by those who only look at this number. Such investors look for "low P/E" stocks. These are companies that have a very low price relative to their trailing earnings.

With the advent of computerized screening of stock databases, low P/E stocks that have been mispriced have become more and more rare. When Ben Graham formulated many of his principles for investing, one had to search manually through pages of stock tables in order to ferret out companies that had extremely low P/Es. Today, all you have to do is punch a few buttons on an online database and you have a list as long as your arm.
This screening has added efficiency to the market. When you see a low P/E stock these days, more often than not it deserves to have a low P/E because of its questionable future prospects. As intelligent investors value companies based on future prospects and not past performance, stocks with low P/Es often have dark clouds looming in the months ahead. This is not to say that you cannot still find some great low P/E stocks that for some reason the market has simple overlooked -- you still can and it happens all the time. Rather, you need to confirm the value in these companies by applying some other valuation techniques.

Let us now look at a real example. On 31 May 2000 the price of the shares of a company was Rs.465. The company declared a dividend of 65% for the year ended March 31 2000, and earnings per share of Rs.13.3. If we assume that this dividend will remain constant, and that a P/E of 20 is reasonable, the intrinsic value of the company's share should be Rs.266. If the company's earnings grow at 20% per year the EPS at the end of 3 years would be Rs.22.98 (13.3 x 1.20 x 1.20 x 1.20). On that assumption, the price at the end of 3 years would be Rs.459.60 (EPS x P/E of 20). Based on an expected return of 20% the intrinsic value today will therefore be;

6.5/(1.2) + 6.5/(1.2)^2 + 6.5/(1.2)^3 + 459.6/(1.2)^3 = Rs. 280

The company's share price at Rs.465 was nearly 67% above its intrinsic value and on the basis of this submission should be sold.

The P/E ratio reflects the reputation of the company and its management and the confidence investors have in the earnings potential of the company. An investor may well ask what should be the P/E ratio of a ompany; at what price should one purchase the share of a company. We'd like to introduce, at this juncture, a school of thought promoted by those I term the the developing economy proponents. They argue that the average P/E of shares in developing economies, i..e in countries in South East Asia, average 45. They claim that P/Es have to be higher in developing economies as companies are growing and the high P/Es reflect this growth. As companies mature, earnings will stabilize and the P/Es fall. That may be. In my opinion, though, I feel that in India it would be safer for investors to buy shares of companies that have a relatively lower P/E (between 11 and 13). One should think twice before purchasing a share that has a higher P/E..
The subjective assumptions made in arriving at the intrinsic value results in the intrinsic value of a share being different for different individuals. This method, however, is extremely logical. It considers the dividends that will be paid and the likely capital appreciation that will take place.

Disclaimer: Messages and ideas in this post is a personal opinion and the author is not responsible for any gains or losses incurred based on the idea.

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