Question 1. Is it cheap?
Posted on January 26, 2009 by Richard Beddard
Filed Under Investing |
It’s a PE ratio, but not just any old PE ratio
Last week I boiled the way I pick shares down to three questions, the only three that count. Having spent most of the blog building up to that point I didn’t elaborate, leading Mike to comment:
It is useful to have a checklist but I think it is dangerously seductive to think that successful investing can be distilled into answering just three questions.
Quite right. So perhaps I should reveal that there is more to these three questions than meets the eye. Taking them in turn:
1. Is the company cheap?
I usually use the long-term price earnings ratio to determine how cheap a share is. That’s the average of five to nine years of earnings per share divided into the price (per share). I would use up to ten years, but my data only goes back nine. Companies with less than five years of earnings don’t have much of a record, so I don’t bother with them.
Earnings, profits, are important because they belong to the investor after the company has paid all its bills. We benefit directly, through the dividend, or indirectly through money retained by the company and invested to make more money. Our ownership entitles us to a share of the profit, which we’ll reap as a dividend or through a rising share price, assuming the company invests retained profits well.
The long-term average is important because the most recent year’s profit or analysts’ forecasts for the current year, the profit figures used in the price earnings ratios you see quoted in newspapers and on websites, may not represent the company’s true earning power – that is how much it might earn in a typical year. If you base your decision to buy a stock after a particularly good year, you’ll be disappointed when it fails to meet your expectations in subsequent years.
To help protect me from clever accountants fiddling the profit figure, I compare a company’s record of profits to its record of cash flows, the actual money coming in and leaving the company. If the latter is markedly inferior to the former, I forget about the company.
By comparing the price of the company to its average earnings, we find out how much we’re paying for a typical year’s profits, ten times earnings, for example, if a company’s price earnings ratio (price per share divided by earnings per share) is ten.
As it happens, ten times earnings is quite a good price to pay. Assuming the profit is your return, you can do the division the other way, divide the price per share into the earnings per share to calculate what fraction of the investment you would receive as profit, in theory, every year (it wouldn’t work out that smoothly). A company on a price earnings ratio of ten would yield 10%.
The earnings yield is a convenient figure because you can compare it to the returns you might get from money in the bank (interest) or invested in bonds (yield). Ten per cent is OK and although I might pay more, and therefore accept a lower return now, for a company I expected to earn much higher profits in the future, I’m not sure I’d ever bother with the hassle of investing in shares for less than 5% (a long-term PE ratio of about 20).
That’s what I mean by cheap. Typically, I like to pay up to ten times long-term average earnings. Sometimes I’ll pay up to sixteen times, but rarely more than that.
Does it work in practice? Dr Keith Anderson, now at the University of York back-tested an eight-year price earnings ratio on UK stocks and found that shares with the lowest PE’s returned 6% more a year than shares with the highest PE’s, almost twice the premium of a conventional PE ratio. James Montier, analyst at SG, tested long-term PE ratios globally with similar results (I don’t have his excellent book to hand, so I can’t give you the figures). Benjamin Graham, the granddaddy of value investing, inspired them both. He favoured the long-term price earnings ratio.
Of course, shares are often cheap for good reason - they’re stinkers. They’re going bust, or they’ll never earn the profits they have in the past. I try to protect myself from them, and boost my returns, with questions two and three, which I will have to explain later in the week as this blog has seriously run over. 
Footnotes:
- By the way, The Times’ Money Central has put us in its list of top twenty British personal finance blogs. Thanks Times Online Money Desk people!
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[...] three of a three-part mini-series. In part one I said there are only three questions that count. In part two, I explained how I decide a company is cheap (question 1). In this part I’ll explain how I decide [...]
[...] sheet calculates the long-term price earnings ratios of the all the companies, and divides them into three categories: Cheap companies that have ltpe [...]
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[...] Low prices in relation to profits averaged over five to ten years. [...]
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[...] are, potentially, as, even at 52p, Solid State’s ten-year price earnings ratio is about ten, my arbitrary upper limit for a bargain [...]
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