The Price to Earnings Ratio (P/E) is one of the “go to” metrics for most investors, brokers, and funds when in the very early stages of vetting an investment idea. It gives an indication of how much the market is willing to pay for a stock in terms of its earnings. It essentially tells you “How many years will it take for me to get my investment back from earnings?”
To calculate the Price/Earnings is a simple calculation:
Earnings per share/market price per share
For example, if a company makes $50m in net profit after tax (NPAT) and currently has a market capitalisation of $600m, then it has a P/E of 12x.
Interestingly, the inverse of the P/E ratio is the earnings yield, being earnings per share / price per share. This means that as the price/earnings gets higher, the yield gets smaller. In real terms, this means that each year, your investment will return a lower percentage as the P/E increases.
So, if I gave you the option to invest in Company A with a P/E of 9x earnings or Company B with 22x, which one would you pick?
You might say Company A because it is cheaper and has a better yield, but the correct answer was “I need more information”. The P/E actually tells you less than you might think. It is only useful when used in conjunction with other related metrics, like how much the company is expected to earn next year.
These two examples are actually real companies. Company A is ANZ Banking Group (ASX:ANZ) and Company B is Vita Group Limited (ASX:VTG). ANZ might be cheaper in terms of how many years it will take for the company to return the investment to the investor (9 years vs 22 years), but ANZ have only returned an earnings per share (EPS) compound annual growth rate (CAGR) of 7.5% in the last 3 years, whereas VTG has returned 33%.
Now which stock would you rather own?
Generally speaking, a high P/E will mean that investors are willing to pay a higher price in expectation of higher earnings growth. Mature companies generally have lower P/E’s (such as the banks) as their size and market penetration makes it harder for them to grow. Conversely, startups and high growth small caps often have high PE’s simply because they are growing from a smaller base. But it’s important to note that the P/E is a reflection of growth expectations, not so much the maturity of the business.
So do value investors prefer stocks with high or low P/E’s?
The answer is the same as our first question: it depends. It depends on the future trajectory of the business and likelihood it will achieve this. The struggle for value investors then becomes finding an undervalued, high growth company.
Warren Buffett would say that growth and value are joined at the hip, which can at first sound contradictory after our discussion above (since high growth often leads to a high P/E), and because high growth companies often seem overvalued using both P/E valuation and a DCF Valuation.
But by using a PEG (Price/Earnings to Growth) ratio, we can give a high P/E ratio context by taking into account the growth expected for the year.
The PEG Ratio
The PEG ratio is calculated as:
The P/E ratio / (Growth rate x 100).
A PEG ratio of around 1.0 means that the P/E is an acceptable level based on the EPS growth expected for the year. Below 1 is ideal as it suggests the market may have mispriced the stock based on earnings projections. Similarly, a company with a PEG of 2.0 may also be mispriced the other way.
Using our examples above we can calculate that ANZ has a PEG of 1.2, (being 9 / (0.075 x 100)) and VTG has a PEG of 0.67, (being 22 / (0.33 x 100)).
So using this methodology VTG would seem like the better buy as it has a PEG of less than 1.
Of course, there is much more that should go into the analysis of buying a stock than just the P/E and the PEG ratio, but this is one way to assess quickly whether or not a company is worth looking at based on its growth profile and market valuation.
At Farnam we like to know quickly whether or not a stock is worth doing more research on. Using the PEG is one such preliminary measure we use to scan for stock ideas. To learn the other principals of value investing we use in researching all our stocks, read our Value Investing Checklist here.
Farnam owns shares in both ANZ (Growth and Leaders Portfolios) and Vita Group (Growth and Value Portfolios).
This document has been prepared by Farnam Investment Management Pty Ltd (Farnam) ABN 15 149 971 808 AFS Licence 430574. Australian Unity Funds Management Limited ABN 60 071 497 115 AFS Licence 234454 is the responsible entity of Farnam Managed Accounts. While every care has been taken in the preparation of this document it does not contain any recommendations to buy or sell any particular stock(s) noted. Farnam makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation or needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek their own professional advice. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.