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Beware PE traps

This article appeared in the October 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

The price-earnings multiple can be dangerous tool for novice investors.

Photo of Michael Kemp By Michael Kemp, author

Johann Goethe, the German writer, artist and politician (1749-1832), wrote in Maxims and Reflections: "There is nothing so terrible as activity without insight."

I thought this particularly appropriate to a discussion of the price-earnings (PE) multiple. Being one of the most popular financial metrics, PE is certainly applied with great activity, but it is commonly used without insight.

This article explores what PE is actually telling us and, more importantly, not telling us. For many readers, there will be some surprises.

Calculating PE

Understanding of the price-earning multiple varies widely. Most investors know how to calculate it: dividing the current share price by the most recently reported earnings per share (EPS) is fairly straightforward.

The problem is many investors then use it as a measure of relative value; that is, a company with a low PE is judged as cheap and one with a high PE is judged as expensive. This relationship is a very weak one.

More often, low PE companies deserve the rating they receive. So to place undue reliance on PE as a shares selection tool can result in some very poor investment results.

The belief that it indicates relative value stems from its origins. The PE was adapted from a property valuation tool first used centuries ago by England's landed gentry. Commercial property was valued by capitalising its annual rental stream. The multiple applied was referred to as "number of years purchase", which was effectively just a PE. To do this is OK when the earnings stream is steady, like the rentals flowing to the landed gentry. But it's a completely different ball game when applied to earnings per share, which does not remain constant.

Because PE is calculated by dividing the current share price by the last reported earnings per share, the numerator (the current market price) is continually updated. But the denominator (the earnings per share) is only as current as the last financial statement. Therefore, price-sensitive information released since the last earnings report will be incorporated into the numerator but not the denominator.

A recently announced profit downgrade will see a conventionally calculated PE fall and therefore send out a false signal that the company is cheap. In an attempt to overcome this deficiency, the PE is often calculated using prospective, rather than historical, earnings. But this means dusting off the crystal ball, with all the inherent problems that introduces.

Variables affecting the PE

I've barely scratched the surface regarding problems with the PE, so let's move the discussion up a gear or two. Armed with the following you might conclude, as I have, that the PE is virtually useless in making value judgements about individual companies. I once heard the fund manager Roger Montgomery describe the PE as "twaddle"; it was an apt summary.

I'm going to introduce some of the main variables driving the PE. There's no space to cover them all, and the big one I've left out is investor sentiment. I ask that you now enter a synthetic world - the world of economic assumptions. When things get complex, as company valuation can, this is the only way we can conceptualise the issues at hand.

Begin with a formula used by valuation theorists to justify a company's price-to-book ratio:

P      ROE - g
B =   r - g

Where:
ROE = Return on equity (book value)
g = annual growth in earnings
r = Discount rate (required rate of return).

Since it's a given that EPS = ROE x book value per share, then dividing both sides of the above equation by ROE provides a platform for discussing the variables affecting the PE ratio.

P      ROE - g
E =   ROE (r - g)

The right-hand side of the equation shows the PE is affected by variations in ROE, growth in earnings and the discount rate applied to the valuation. The discount rate is in turn determined by the inherent risk of the investment and prevailing interest rates. And because no two companies are likely to ever display the same mix of these complex (and largely immeasurable) parameters, the PEs carried by any two are not comparable.

Let's use the above formula to develop an example.

Growth, but at what cost?

It is often said that investors should select companies with the highest prospective earnings growth. That's usually good advice but only under certain conditions. For it to hold true, the company must deliver a return on equity higher than the return you demand of your investment (referred to as the discount rate or required rate of return). If it's lower, all bets are off. Consider the following:

  • Company A: is expected to deliver ROE of 8 per cent and earnings growth of 1 per cent per year. The market has it on a PE of 9.7.
  • Company B: is also expected to deliver ROE of 8 per cent but higher earnings growth of 6 per cent. It's on a PE of 6.25.

Both companies operate in the same industry and have similar risk profiles. Because you have heard somewhere that it's OK to use the PE as a basis of comparison when companies are operating in the same industry, you have decided company B, with the lower PE, is the one to buy. Strengthening your conviction is its higher anticipated earnings growth.

You have just fallen into the "PE trap" - by being fooled into believing the lower PE was because of the market undervaluing company B. You have even confirmed this in your mind by noting it's the one with the highest growth in earnings. But the reality is that this low PE does not represent unrecognised value at all. In fact if you factor in a 10 per cent discount rate, the PE that the market has pinned on company B is quite realistic.

The key to understanding this lies in the low anticipated return on equity for both companies. The return of 8 per cent is lower than the 10 per cent you are demanding.

What both of these companies are doing is destroying value, and company B, with its higher rate of earnings growth, is destroying value at a greater rate than company A. Neither represents an investment you should be making. To the uninitiated it all sounds a bit counter-intuitive but once you understand this nuance you will make better investment decisions.

The PE as a screening device

Investors often use the PE as a screening device. Using a low PE they first sift through the more than 2000 companies listed on ASX to come up with a short list for further analysis. This is a bit like fishing with a torn net; a lot of good fish are going to get through and you will gather a lot of fish you wish you hadn't.

You will miss companies carrying a high PE that is justified - those demonstrating high growth and a return on equity well in excess of your required rate of return. Equally unfortunate is that you will haul in companies such as the two described in the above example.

I don't rely on the PE for any of my investment decisions. On that note, I wish you happy fishing.

About the author

Michael Kemp has had a long career in Australian financial markets. Following the release of his first book, Creating Real Wealth, in 2010, he now works as a freelance financial writer.

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