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High PE stocks that are still good value

This article appeared in the May 2014 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.

A higher Price Earnings ratio does not always mean a stock is expensive.

Photo of Richard Hemming By Richard Hemming, Under the Radar Report

Technology stocks are the Ferraris of global sharemarkets because they are able to generate extreme levels of growth with relatively low risk, once they get going.

We are talking about earnings growth in excess of 20 per cent a year over many years, which should involve little in the way of capital expenditure to maintain. When you think about the current 2-3 per cent growth rate of the Australian economy, and the global economy being closer to 2 per cent - to which most companies' prospects are tied - this technology stock feat is even more impressive.

That is why investors are willing to pay price-earnings (PE) multiples in the region of 30 times to gain a stake in these technology companies. Even with the sharemarket trading at relatively high historical levels, this is expensive. The average PE multiple for companies on ASX is about 13 times current year's earnings.

Technology companies trade on high multiples because their business models, if successful, are so revered by investors.

Once these companies get it right, there is little incremental cost in extra product sales, and literally billions of dollars flow to shareholders, in large tech corporations. Look at the big successes such as Microsoft, Apple and Google, and closer to home, internet employment ads specialist Seek, online car retailer Carsales.com and realestate.com.au owner REA. Then there is arguably Australia's biggest corporate success story, the medical research group CSL.

What the PE means

A PE ratio is simply the proxy for how most investments are valued: the present value of the future earnings streams that are available to investors. Note that it is future and not past earnings streams that count, which is why forecast PEs are considered more valuable for high-growth companies than PEs based on historic earnings. Valuation theory is not predicated on what has happened in the past.

The return to owners of capital, or equity, investors has historically been the dividend, which is why the equity valuations have traditionally been based on the dividend discount model:

  • price divided by the dividend equals 1 divided by (k-g).

'k' is the required rate of return for equity investors, or put another way, the discount rate applied to the company's future cash flows; while 'g' is the expected growth of those future earnings.

Dividends increasingly are being replaced by earnings in the model, in a nod to the fact that most investors invest in stocks to achieve growth in their capital (via the final sale price) rather than for a dividend stream.

If we are talking about PE being a proxy for valuing a company, it is more accurate to use the earnings discount model where earnings are substituted for the dividend. So PE = 1/(k-g).

When is the PE too high?

In the past couple of months technology stocks have been sold off as investors have become sceptical about their ability to actually make the returns in hard cash implied by their stratospheric valuations.

Many of these companies have been trading on PE multiples of over 40 times and in some cases on revenue multiples upwards of 30 times, which is reminiscent of the tech boom in 2000, which preceded the tech wreck.

We have told subscribers we believe this provides buying opportunities in one of the best areas to harvest big returns.

Many others must have thought the same. The US-based NASDAQ index, which fell just over 8 per cent between early March and mid-April, at the time of writing had bounced about 4 per cent in two weeks, from 4000 to its current level of 4148.

There is no doubt there has been too much hype in sections of the technology marketplace for stocks. If the stock had anything to do with mobile technology, it was priced like a gold mine, with stratospheric returns anticipated from developments at Apple Inc; the growing use of smart phones and tablets; and people spending more time on these devices.

Although there are examples of big money being made, these companies are essentially software providers, which involves massive risks around development. It is often a binary calculation: if it works, it's off to the races; when it doesn't, as is often the case, you lose all your money.

Another important point is that the technology market is much more mature than it was in 2000, when there was a mad scramble among almost every company in the technology field. Now there are some clear winners, even though the competition is still only a click away.

Australian high-PE stocks

Leaving aside the Googles of this world, in the Australian market many consider that REA, Seek and Carsales.com have an unassailable lead in terms of online advertising in their respective "verticals" of real estate, employment and automotive sales. These companies have massive operating leverage, being able to grow profits at faster rates than revenues because they do not need to increase costs in order to sell more products.

This is nirvana for investors because it translates into strong free cash flow. This is operating cash flow minus capital expenditure and refers to the moneys that goes towards building the company, or paying to investors.

These stocks are trading at high PE multiples because investors think they will produce 15 per cent-plus earnings growth, year after year. If we were to translate this into the dividend discount model terms, this means that 'g' is high and because certainty is high, 'k' is low.

There is a point at which these companies are too expensive, but because the field they are operating in is changing, and that change is often led by these operators, they keep cranking out the 20 per cent growth in earnings that investors love. Hence their big multiples are justified, until they are not.

What about smaller stocks with high PEs?

For most technology companies, especially those that are starting up, investors are looking for high earnings growth, but you should note there is high risk attached.

Companies in technology and also biotechnology that we do not touch include those that do not have any underlying earnings stream. These companies really are all-or-nothing bets, and the nature of the technology beast is such that they will need to come back to the market time and time again, and their technology may not succeed in any event.

For example, look no further than the recent 80 per cent-plus falls in Prana Biotechnology (PBT), which is developing a treatment for Alzheimer's, and in QRxPharma (QRX), a company trying to commercialise a pain relief medicine.

We look for technology companies that are starting to grow their earnings and have a technology that can produce strong growth in the group's valuation. (Editor's note: Do not read the following ideas as stock recommendations. Do further research of your own or talk to a licensed financial advisers before acting on themes in this article).

A classic example is eServGlobal (ESV), which climbed as high as $1.09 and has come off to about 80 cents, the level it was at in early January after a deal with MasterCard transformed its HomeSend business. HomeSend enables people who live in affluent countries, but come from countries such as India and the Philippines, to send money home via their mobile phones, which is much cheaper than using the traditional method such as through Western Union.

Back to valuation theory

It is a mathematical certainty that companies investors consider will achieve high growth will be given a high PE. However, there is much, if not all, that is subjective. The two unknowns are on the right-hand side of the earnings discount model - the discount rate and the growth rate.

Valuation theory says that suppose you have two companies A and B, and investors assign the same discount rate to each of the company's future cash flows. If company A has a higher expected growth rate for its earnings, it will receive a higher PE than company B.

But importantly, valuation theory says nothing about the relationship between 'k' and 'g'. This is where investors can make erroneous assumptions and get hurt financially. In the dotcom bubble, investors' expectations of 'g' were too high and their expectations of 'k' were too low.

People were saying this was happening again during the recent bout of tech selling. In some cases we did not agree, as with eServGlobal, which is why we advocated there were some buying opportunities. It's a subjective call.

About the author

Richard Hemming is an independent analyst who edits Under the Radar Report, which provides investment opportunities in small caps that you won't get anywhere else. Receive a free 30-day trial of Under the Radar Report. Its 10 stocks have an average return of more than 250 per cent in the past year.

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