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Great company - but great buy?

This article appeared in the April 2013 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.

Here's a really good article on the conundrum of “worth” and “acceptable” return, and how PE ratios can help.

From Morningstar

Imagine you have applied your toolbox of strategies to a number of companies and found one or two that appear to fit the bill. They are in attractive industries, have solid core businesses, good track records, sound management, strong earnings growth and the outlook for continued growth looks reasonably positive.

In fact, the overall picture looks so good that you are starting to ask the big question: should I buy? Of course, the answer is just another question: how much does it cost?

Finding great companies and great investments is not the same thing. If years of expected future earnings growth has already pushed a company's share price to very high levels relative to other stocks, you may have to look elsewhere.

Fortunately, there is no shortage of independent research and brokers' reports to help you work out how much is too much to pay. These are a useful rough price guide, but the fact that they are printed in black and white draws some investors into giving them a legitimacy they do not always deserve.

No one can truly say what a stock is worth. The ultimate judge is Mr Market, given enough time.

In the textbooks, the value of a company is the net present value of its future free cash flows (cash that is not required to be invested back into the business). This basically means that a company is theoretically worth all of its future profits added up, expressed in today's dollars.

An investor's job is to identify a price at which the company's earnings will produce an acceptable return on investment.

If a company continues to generate earnings and produce acceptable "internal returns", this should eventually be recognised by the sharemarket, although it may take some time, and the price will rise - as will dividend payments.

What return is acceptable?

An "acceptable" return means different things to different people, but generally it starts with the rate of return you would earn if you put your money into government bonds - the so-called risk-free rate of return or the current yield on 10-year government bonds. (It is known as risk-free because in the unlikely event of a government default, an investor is guaranteed to get their capital back).

Analysts may then add a risk premium of perhaps 3 or 4 per cent, sometimes more, for what they consider an acceptable reward for holding the stock. Anything lower than the risk-free rate and there is obviously no incentive to take the extra risk in buying shares.

Analysts typically run these calculations through complex mathematical modelling procedures and apply various filters to weed out companies with undesirable or "risky" characteristics before arriving at their interpretation of a company's "true value".

Every analyst does this in their own way, making their own assumptions, allowing their own margins for error, and so on. Under its methodology, Morningstar considers risks to a company and assigns an Uncertainty Rating to it in order to determine the cost of equity.

There is no point pretending the average private investor can go through processes like these; even estimating future earnings growth is fraught with difficulty. But rather than worrying about this, you should take advantage of all the legwork that has been done on your behalf by experienced professionals, such as those as Morningstar.

There are also some relatively straightforward approaches you can take to estimate at what price a stock is worth buying.

Assessing when to buy

Despite its imperfections and limitations, the price-to-earnings ratio (PE) is still the most useful starting point for working out whether or not a stock is cheap or expensive. After putting the company through a rigorous analysis, you can start by comparing its current PE to:

  • The historical trend in its PE
  • The market average PE
  • The sector average PE
  • Competitor company PE.

This brief check should already give you some idea of the company's current value relative to other stocks.

You can then take forecasts of growth in earnings per share (EPS) for, say, the next three years, and work out a forward or prospective PE for each of those years.

This will give some guide to the potential for share price appreciation, although the accuracy will obviously depend on the earnings growth forecasts, as well as the market's reaction to them.

A worked example

Bogan Steel Limited is trading at $1.00 a share with earnings per share (EPS) of 5 cents, so its current PE is: 100 cents per share / 5 cents per share = 20.

In most markets, such a PE would be considered roughly fully valued for a company with reasonable earnings growth (in a bull market it would probably be considered quite cheap). But let us assume in this case that Bogan Steel's PE is well-justified by current earnings growth.

Suppose your assessment of Bogan's earnings prospects, management and so on, combined with reports from Morningstar, suggest the company will grow its current earnings (5 cents a share) at 15 per cent compound per annum for the next three years.

Assuming its share price stays at $1.00, by the end of year one, its PE will have fallen to 100 cents per share / [5 + (0.15 x 5)] cents per share = 100 / 5.75 = 17.

By the end of year two, its PE will be down to 100 cents per share / [(5 + 0.15 x 5) + (0.15 x 5.75)] = 100 / 6.61 = 15.

By the end of year three, its PE will have fallen to 100 cents per share / [(5 + 0.15 x 5) + (0.15 x 5.75) + (0.15 x 6.61)] = 100 / 7.60 = 13.

Bargain! That's assuming, remember, that its share price has not changed over the period, even though its earnings are rising. If its share price does stay flat at $1.00, you will be holding Bogan Steel three years later at a much lower PE, having achieved zero capital growth.

If, however, investors feel much the same way about the stock in three years' time as they do now (investors are, on average, neither more nor less confident about its future), Bogan Steel may preserve its PE of 20 on year-three earnings of 7.6 cents per share.

That gives us two parts of the PE equation.

Now we fill in the third to see what the company's share price would have grown to:

Price-to-earnings ratio = current share price / earnings per share. So share price = earnings per share x PE ratio = 7.60 x 20 (remember the PE has not changed this time) = $1.52.

Preserving a PE of 20, which indicates that investors are expecting reasonable growth for years four, five and so on), the share price has risen from $1.00 to $1.52, or 52 per cent, in three years.

Chances are that Bogan Steel has also increased its dividend payments pretty much in line with the increase in earnings.

If Bogan pays out 50 per cent of its earnings as dividends, its dividend per share will have increased from 2.5 cents at the start, to 2.9 cents at the end of year one, 3.3 cents in year two, and 3.8 cents in year three - the same 52 per cent increase.

The potential return from Bogan Steel is obviously well above the risk-free rate of return from government bonds, and theoretically well worth the additional risk.

But don't buy the stock just yet

Ignoring broader market conditions, which no one can confidently predict over a period of three years, the answer to whether to buy depends on two key factors: the alternative opportunities available at the time (can you do even better than Bogan?), and the probability of the company achieving those earnings forecasts.

How likely is it that the company will meet or exceed its earnings growth forecasts? Are those forecasts conservative or aggressive? And how significant are the risks to the outlook implied in those forecasts?

Although 52 per cent growth in share price and dividend over three years is obviously nothing to sneeze at, nor is it the upper limit to the stock's potential.

Imagine that during the three-year holding period it becomes obvious that Bogan Steel will easily achieve 15 per cent compound earnings growth for three years, followed by 20 per cent compound earnings growth for some time after that. (We are being a little optimistic in this example, of course. In real life, remember, the vast majority of stocks will not do this well.)

There is every chance that other investors will now become much more interested in the stock and push its PE above 20. Investors may in fact decide that Bogan is such a terrific growth story that they are prepared to pay 25 times current earnings, which means the share price after three years will be:

Bogan's share price = earnings per share x new PE ratio.

Bogan's price-to-earnings ratio = current share price / earnings per share.

So, Bogan's share price = earnings per share x PE ratio = 7.60 x 25 (remember the PE has been upgraded) = $1.90.

Checklist

Let's draw together the threads of this conversation into some more precise guidelines about when to buy a long-term investment stock.

  • There is no point buying a stock if you do not expect it to generate an "acceptable" return, which in most cases should be a reasonable premium to the risk-free rate.
  • Although PE ratios are a useful starting point for assessing value, share price growth over the long term depends on growth in earnings per share over time. Mathematically speaking, PEs reflect current earnings, and stocks currently trading on high PEs may outperform low-PE stocks if they have superior earnings growth.
  • Every decision to buy or not to buy is relative to the alternatives, and you should try to compare one stock's potential to another's to gauge the best possible place for your investment.
  • Regularly question the resilience of the earnings growth forecasts provided and the likelihood of the company achieving them.
  • There is no "best time" to buy a stock because things can change overnight in the markets. If you find a good company trading at a reasonable valuation, there is usually no better time. If you wait for perfect conditions, they may never come.
  • Remember to buy stocks that suit your personal investment objectives. Always be clear in your own mind about whether you are looking for a long-term investment or a speculative trade.

About the author

Morningstar is a leading investment research house.

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The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

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