Perplexed by PERs? - Part 1
Value investing is theoretically simple: buy assets for less than they’re worth and sell when they approach fair value (or above). So too is valuing assets: discount future cash flows back to today at an appropriate interest rate for the life of the asset. The discounted cash flow (DCF) model is a commonly-used tool, hammered into every finance and business student.
But models have limitations.
DCF models quickly deteriorate when they come up against a rapidly-changing world. Worse still, the misleading precision imbues investors with unwarranted overconfidence. Too often, models are precisely wrong.
But other tools are available. The price-to-earnings ratio (PER) is a regularly-used proxy for stock valuation. In this article and the one that follows, you’re going to learn what it is, how to calculate it, when and when not to use it.
Key Points
- The PER can be a useful but imperfect valuation shortcut
- It’s easy to calculate but interpretation is the key
- High quality companies generally deserve higher PERs
PER 101
Let’s start with a definition: A PER is a ratio that compares the current price of a stock with the prior year’s (historical) or the current year’s (forecast) earnings per share (EPS). Usually the prior year’s EPS is used, but be sure to check before relying on someone else’s numbers. Let’s demonstrate with an example as summarised in Table 1.
2009/10 | 2010/11 | |
---|---|---|
a) Net profit ($m) | 8.0 | 10.0 |
b) Shares outstanding (m) | 1.0 | 1.0 |
c) EPS ($) (a/b) | 8.00 | 10.00 |
d) Share price ($) | 100.00 | 100.00 |
e) PER (times) (d/c) | 12.5 | 10.0 |
Last financial year, XYZ Ltd made $8m in net profit (or earnings). The company has 1m shares outstanding, so it achieved earnings per share (EPS) of $8.00 ($8m profit divided by 1m shares). In the current year, XYZ is expected to earn $10m; a forecast EPS of $10.00.
At the current share price of $100, the stock is therefore trading on a historic PER of 12.5 ($100/$8). Using the forecast for current year’s earnings, the forward or forecast PER is 10 ($100/$10).
What does a PER actually mean?
It’s often said that the PER ratio is an estimate of the number of years it’ll take investors to recoup their money. But this is incorrect unless all profits are paid out as dividends, something that rarely occurs in real life for a sustained period. So ignore what you might read in simplistic articles and note this down; a PER is a reflection not of what you earn from a stock, but what investors as a group are prepared to pay for the earnings of a company.
All things being equal, the lower the PER, the better. But the list of caveats is long and all-important. Before we assess whether any particular PER is reasonable, remember a lesson you know from shopping: quality usually comes with a price to match. It costs more for handcrafted leather goods from France than a cheap substitute from China. Stocks are no different; high quality businesses generally, and rightfully, trade on higher PERs than poorer quality businesses.
We all love a bargain and value investors are defined by this quality. A low PER for quality businesses can be indicative of good value, and suggests a stock might be worthy of further research. But a low PER alone doesn’t guarantee that the stock is a bargain. Remember, PERs are only a shortcut for valuation.
Likewise, a high PER doesn’t ensure that a stock is expensive. A company with strong future earnings growth may justify a high PER, and may even be a bargain. Another stock with temporarily depressed profits, especially if caused by a one-off event, may justifiably trade at a high PER. But for a poor quality business with little prospects for growth, a high PER is likely to be unwarranted.
That’s not all you have be careful with; PERs are often calculated using reported profit, especially when done in bulk in newspapers or on financial websites. One-off events often distort headline profit numbers, and therefore the PER. Using underlying, or ‘normalised’, earnings in your PER calculation is likely to give a truer picture of a stock’s value.
Of course, all this begs the question; what exactly is a high or low PER?
We’ll get to that in Part 2. We’ll also delve into more advanced issues and current examples, as well as covering a few of the pitfalls associated with this metric. So have your pencil sharpened for next fortnight.