Marcus PadleyTHIS MONTH
The problem with PE
There is a measure that gives investors a more realistic idea of a stock’s worth
Y
ou all know what a PE
ratio is: it is the price
of a share divided by
the earnings per share in a
particular year. So if a com-
pany share price is $1 and it is
earning 10¢ per share this
year, it is on a PE ratio of 10.
But there are a variety of
problems with PE ratios and
on its own a PE really doesn’t
tell you very much. It appears
to allow you to compare how
cheap or expensive compa-
nies are relative to each other but it has a
major flaw. It doesn’t take account of earn-
ings growth. It’s no good, for instance, say-
ing a company that is on a PE ratio of 20 is
expensive and another on a PE ratio of 10
is cheap, if the company on 20 is growing
earnings at 40% a year and the company
on 10 is seeing no earnings growth at all.
Unless the companies you are comparing
are identical in every way, including earn-
ings outlook, strength of balance sheet,
industry dynamics, risk and many more
possible investment variables, you really
can’t compare them on PE ratio alone.
To make the point, there is a theory that
if you take the 10 stocks with the highest PE
ratios at the beginning of the year they will
always outperform the 10 stocks with the
lowest PE ratios over the next year. Here
is a real-life example:
- The highest PE ratios in the top 100
industrials at the time of writing include
CSL, Cochlear, Domino's Pizza, ResMed,
REA Group, Treasury Wine Estates, Seek,
Amcor, Brambles, Aristocrat Leisure,
Computershare and Ramsay Health Care. - Meanwhile, the lowest PE ratios in the
top 100 industrials include Harvey Nor-
man, TPG Telecom, Bank of Queensland,
National Australia Bank, Commonwealth
Bank, Westpac Bank, Lendlease, Bendigo
and Adelaide Bank, Telstra and AMP.
If it’s growth you’re after, I think I know
which portfolio you should be holding. But
the PE ratio doesn’t tell you that; instead, if
Marcus Padley is a director of MTIS Pty
Ltd and the author of the daily stockmarket
newsletter Marcus Today. For a free trial of
the newsletter go to marcustoday.com.au.you use the PE as a filter on its own, it sim-
ply directs you to the low-growth, boring
stocks. On the flipside, high PE ratios are
the market identifying growth for you.
And there are other issues with PE ratios,
most notably that earnings per share num-
bers are a function of accounting standards
and techniques. If, for instance, as hap-
pened in the 1980s, management was paid a
bonus depending on the declared earnings
per share number, it could (and still can)
do all sorts of things to manipulate a higher
published earnings number. There was a
very good book about it 20 years ago called
Accounting for Growth – Stripping the Cam-
ouf lage from Company Accounts by my old
boss in London, Terry Smith, all about cre-
ative accounting by listed companies.
Another issue is that some companies,
such as a lot of infrastructure stocks, can’t
be assessed on published earnings because,
having spent billions of dollars upfront
building assets, they then spend the next
few decades minimising their statutory
earnings and tax by using their huge depre-
ciation and amortisation provisions to
bring their earnings as close to zero as pos-
sible. This is why a lot of infrastructure
companies don’t rate on any “value”-based
analysis or intrinsic-value analysis.
Another issue with the PE ratio is that it
only relates price to earnings, not to risk.
You could have two companies on the same
PE ratio but one could have cash on the bal-
ance sheet and the other 200% gearing.The PE ratio tells you
nothing about the bal-
ance sheet or risk.
So we need some-
thing better, and that
comes in the form of
what is called the PEG
ratio, or PE ratio-to-
earnings growth ratio.
The PEG ratio
relates the PE of a com-
pany to the growth in
earnings. In the eyes of
some fund managers,
mostly active growth-orientated fund man-
agers, when it comes to filtering stocks on
ratios, this is the best filter in the business.
To calculate the PEG ratio you simply
divide the PE ratio by the earnings per
share growth rate for any particular share.
So if a company is on a PE of 10 and is
growing earnings at 10%, the PEG ratio
is 1. Now we can compare companies tak-
ing growth into account.
It follows from the maths that the lower
the PEG ratio the better. So what is a good
PEG ratio? Generally, a PEG ratio of over 2
suggests a stock is expensive and a PEG
ratio below 1 puts it on the radar. And if a
PEG ratio of 1 is fair value, which is custom-
ary thinking, then a PEG ratio above 1 sug-
gests that the share price is overestimating
the growth in earnings. On that basis the
stock is overpriced. And vice versa: a PEG
ratio under 1 suggests that the market is
not pricing in the growth in earnings.
To prove the point, some of the highest
large company PEG ratios in Australia
include Wesfarmers, Harvey Norman,
NAB, CBA, Westpac and ANZ. Now
maybe you understand why the bank
sector is struggling to recover. It’s all
about growth, and to spot that the PE
is useless and the PEG ratio is better.