PERs in practice - Part 4
Here's a 'tin tacks' explanation of a PER. So let's begin with that before moving on to a summary of the points we've covered over the last three parts of this series.
If you've ever put money in the bank then you will have considered the return being paid to you. It's expressed as a percentage of the amount you have deposited. For example, a $100 term deposit paying 5% interest per year would generate $5 in annual interest (or 'earnings' in sharemarket terminology).
It's plain to see what your return is - in fact it's implicit in the rate itself. But, for some reason, those involved in the sharemarket prefer to express it in a different way.
Invert
Instead of dividing the interest by the amount invested to determine the rate of return, they prefer to stand the equation on its head and consider the amount invested (price) divided by the interest (earnings).
This gives the price as a multiple of the interest/earnings, instead of the interest/earnings as a percentage of the price.
So, in our bank account example, the 'price' is $100 and the 'earnings' are $5. Dividing the former by the latter we arrive at a price-to-earnings ratio (PER) of 20 - that is 100/5. So a PER of 20 is the same as a 5% rate of return.
If the amount of interest the bank paid increased to $8, our return would rise to 8%. Can you see what will happen to the PER?
The amount invested (price) hasn't changed, it's still $100. But the interest (earnings) is now $8. So, dividing 100 by 8, we arrive at 12.5, our new PER. It's not rocket science but it is a different, and slightly unnatural, way of thinking about your return.
So if higher earnings mean a lower PER then, all other things being equal, we much prefer investments offering us a lower PER. It's a slightly uncomfortable concept for newcomers to grasp - that a lower PER means a higher return - but quite important.
Assessing a stock's PER is one of the more common ways we determine whether it is cheap, expensive or simply fair value. But, more often than not, the PER you read in the press requires some tweaking to make it more useful.
In Part 2 we discussed the thorny issue of significant (or 'one-off') items. We explained that some companies, News Corporation for example, produce 'one-off' losses with disappointing regularity. And, following recent events, AMP could probably be thrown into that basket as well.
We're inclined to add back one-offs for companies where they truly are a rare occurrence.
Cyclical industries
In Part 3 we rounded off our discussion by considering companies in cyclical industries like Graincorp .
We then moved on to a more detailed example using casino stocks Jupiters and Burswood and two insurance stocks, Suncorp Metway and the recently-listed Promina .They are trickier than most because there are two sides to their operations which must be accounted for in a thorough analysis.
In this article we've tried to cover the basics of what a PER is and how to interpret it in broad terms. We've also provided a brief summary of the key points discussed in this four-part series.
The price-to-earnings ratio is a very useful tool but it must be used in the right context. Don't just take the figure in the newspaper (or online) and assume it's realistic - it often isn't. We hope you've found this series useful.