Tuesday, June 01, 2010

PER – simple but limited

A simple article on "Buy & Hold" elicited so many readers' comments. There is a hunger for genuine debate on investing techniques, obviously. In this lackluster market, I have been staying away from focusing on stocks, why not go further to refine ideas on investing.

Too many investors would hold onto low PER as the main decision making trigger. It is an important indicator but we must have a strong appreciation of its powers. Only by realising its limitations, can we use PER effectively.

The price-earnings ratio (PER) is probably the most common financial indicator used by investors. However, there are a lot of shortcomings in relying on just the PER to make financial or investing decisions.

One should also note that the earnings per share is based on net profit and not gross. Plus, it should be fully diluted, that is, it should take into account probable conversions into stock. “Trailing PER” involves taking earnings from the last four quarters, while “forward PER” uses the estimated earnings going forward 12 months.

One of the simplest and safest ways to invest is to judge a stock by its absolute low PER. It is simple as you have the low figure as a buffer and cannot go wrong by very much.

If investing were that simple, there would be no need for data mining and earnings projections, or even analysts' reports. You just sort and search each sector according to historical and forward PERs, and then look at the bottom 10% in PER.

To add value, consider the sector and earnings outlooks. If these are good, then it's a safe investment. You may not get a big bang for your bucks from this investment, but it's safe and sure. If this works all the time, why bother doing anything else? That's because investing using low PER as your main yardstick will not give you market returns or better-than-market returns (alpha). If it did, all fund managers would use that exclusively and we would not need to spend billions on research.

Using low PER as a tool

You won't be the first to discover cheap PER stocks. Rule #1: There must be very good reasons why they trade at low PERs in the first place. One must fully be aware of the whys before going further. Try and locate all the negative reasons before jumping in. Reasons for low PER are aplenty. Some of the more common ones:

  • Sunset industry, enough said
  • Cyclical stocks
  • Capital-intensive industries tend to trade at low PERs
  • Erratic earnings
  • Earnings may have had a huge jump in recent years, making PER low but not likely to be sustainable
  • The PER is low because it is likely to go lower
  • Not liked by funds for good reasons
  • Third-class management with no vision or coherent strategy
  • Jumbled shareholders or management using vehicle as their dumping ground

    Steel stocks have outperformed enormously; cyclically, it still is a good time. It's the same with certain stocks in shipping services. Both are still cyclical stocks. This means their low PER may be upgraded but it won't run very far. Cyclical stocks do not have predictable growth in earnings further than three years. Get the timing correct, but also look for a time to exit. These are not for a buy-and-hold strategy.

    Low PERs usually mean “capital-intensive stocks = low returns on assets” as compared to those in the services industry. Low PER stocks also usually have very high NTA (net tangible assets) per share relative to their share prices. Conversely, high PER stocks usually have low NTA per share relative to their share prices.

    This is because from an investing point of view, NTA only comes into consideration upon liquidation. Certainly, you don't invest in a stock hoping for the company to be liquidated in the foreseeable future. Take Maxis Communications Bhd. Its NTA is less than a quarter of its share price. If you liquidate Maxis today, it would be hell for bondholders and shareholders.

  • Paying for higher PER

    A stock will command a high PER if its business model is scalable without the same proportion of capital investment. If you have a cement plant, you will have to fork out a huge amount of capital to expand elsewhere. If you are N2N Connect Bhd, you can scale up your business into the Middle East bourses with relatively low capital investments.

  • It is highly unlikely that if you were to find a stock at 6x forward PER, you would be the first and only one to have done so. When the timing and conditions are right (like in the last few months), low PER stocks will have their day in the sun.

    Hence, PER is only a minor guide and should not be given undue weighting. Many a times, when a low PER stock is moving, it is not because of the low PER, but rather, because of a confluence of other factors, such as a sector or earnings upgrade, or that cyclically, it's time has come. It just so happens that the stock has a low PER.

    There are many who religiously find comfort in low PER, when in fact they have carved out a universe of stocks for their selection that are largely capital-intensive industries. You might as well say that you would only invest in capital-intensive and/or cyclical industries if you were to embrace only low PER stocks.

    It's not rocket science. An 8x PER stock could still go to 4x PER in a bear market, trust me. A higher PER stock does not mean that it will fall by a higher percentage. Some will cite that artificially manipulated stocks may also have high PERs. But that should not scare people away from them. Just do your homework.

    The best way to use PER in investing is by marking them to their historical PER bands. It is more meaningful to use them within the same-sector PER trading bands.

    It's pretty useless and shortsighted to buy steel stocks at 7x PER and tout them as great buys compared to the market PER of 14x. On the other hand, it's okay to buy a steel stock at 7x PER when its historical PER is 10x and because you like the market sentiment, sector outlook and the stock's fundamentals.

  • http://i426.photobucket.com/albums/pp345/bongban/zhangzilin5-1.jpg

  • An alternative gauge

    Owing to the shortcomings of the bland PER, professional investors tend to favour using the EV/EBITDA ratio. It's very similar to PER. EV is enterprise value and EBITDA is earnings before interest, tax, depreciation and amortisation.

    (Enterprise value = Common equity at equity value + debt at market value + minority interest at market value, if any – associate company at market value, if any + preferred equity at market value – cash and cash-equivalents.)

    Basically, EV is one way of trying to arrive at the net present value of the company. If a company has a lot of cash, the EV can even be negative. EV looks at the company as a going concern. It indicates how much the business is worth after paying off all claims. That's why cash in bank does not count.

    Hence EV/EBITDA is a cashflow measurement or a payback period measurement, while PER is an earnings multiple ratio (or payback period in terms of earnings).

    The former measure is superior because it takes into account the capital structure of the company. One can better compare using EV/EBITDA as it can be adjusted for risk per capital structure of a company to get at the proper returns.

    Interest and tax are external to real earnings, while depreciation and amortisation are not real cashflow items.

    Hence, you would get a better gauge on real earnings minus the peripherals. Still, even though it is a more sophisticated measure, EV/EBITDA also suffers from most of the shortcomings of PER as explained above.


    AQW said...

    fyi, n2n's deal in the mid east isn't going all that well...hence the correction in the price...

    Sweet Like Chocolate said...

    hi ...

    Currently am doing a research on P/E ratio...based on your vast experience ..which books / journals could be used as source of references...especially on your topic?... really appreciate if you could guide me on this...Thank you and Have A Nice Day

    Von Siong said...

    Hi Brother,

    Could you please remove all the gal pic? Just wonder why and most of them is a gal pic , no guy pic?
    Thanks .

    random said...

    von siong

    read this:


    ksq said...

    noted with thanks.

    FattyBomBom said...

    I always use PER as a benchmark for my evaluation for dividend stock. Low PER means more dividend. (REITS)(Haio)

    PER x<14 is also acceptable for me.
    Choosing company with low debt or almost no debt. (Bkawan)

    Choose high growth. (Glove)

    Don't touch those high PER or high debt company. (PN17 - KABOOM)

    Finally, never buy loss making company unless you have a super solid reason like Gpacket.

    I guess im too technical, hope you all understand what im trying to say :P paiseh...

    Thomas said...

    You wrote: "Capital-intensive industries tend to trade at low PERs "
    Can you pls elaborate a little bit on this ? Also can you provide 1 example of such stock?

    Million thanks.

    投资者-无情 said...

    Heveaboard annouced a proposal to list the furniture division,heveapac last thursday,what's your opinion on this proposal.

    Below is part of my analysis,

    1.hevea reported 6 eps for 2010q1,bt most of the profit come from unrealised forex gain(us denominator loan)bt it still manage to get 10mil cash
    before working capital changed mainly due to depreciation and finance cost.

    2.The margin for particleboard increase to 10% at the same time RTA furniture margin drop to 5%.The main reason due to strengthen ringgit toward US dollar.

    3.Based on conservative 5% margin and 180-200mil sales from RTA division,Heveapac manage to lock in 9-10mil profit this year.With valuation at pe 6-8 its value at 60-80mil.If heveaboard going to list it at 80mil and remain 50mil share control,it manage to get 40mil cash due to the listing.

    4.Borrowing stand at 190mil,with the 40mil come from heveapac listing,it manage to pare down the debt,at the same time,depreciation and finaning cost will be lower.

    5.Unlocking value from heveapac is a good idea bcos i belive in future 2-3years time,particleboard margin will improve due to demand so its good for heveaboardbt at the same time will depress heveapac margin(particleboard is raw material for rta furniture)

    All of this analysis purely on fundamentals side,technically heveaboard stock price stilll based on the detail of the proposal,if heveapac is giving free to heveaboard shareholder on listing,then it will give heveaboard share price a boost.Although in long term heveaboard earning will be diluted due to listing.
    From the previous coporate move showed that heveaboard is a family own biz and being very conservative all the time,, i do think that the BOD will distribute the share back to hevea shareholder in order for the YOONG family to control both heveaboard and heveapac.What is your opinion?

    tohff7 said...

    Thomas said...
    You wrote: "Capital-intensive industries tend to trade at low PERs "
    Can you pls elaborate a little bit on this ? Also can you provide 1 example of such stock?

    I think what Dali trying to mean by that is because 1.capital-intensive industry are not easily scalable; and 2. earnings are mostly reinvested since capex requirement are high.

    Good example will be steel industry.

    Yewin said...

    Great post. But, may I know who is the singer of those delicious sexy chinese jazz songs??

    scott grin said...

    You wrote: "Capital-intensive industries tend to trade at low PERs "
    Can you please elaborate a little bit on this ? Also click here
    for some more info related to your topic

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