Let’s say we have two stocks: A Co and B Co.
A Co’s current P/E Ratio stands at 20.
B Co’s current P/E Ratio stands at 30.
So, does it mean that A Co is more attractive an investment than B Co?
Let’s examine.
Here, I’ll share two methods on interpreting their current P/E Ratios.
They will shape my perspectives on their attractiveness as investments.
Before I share the two methods, let’s add some context to both stocks:
A Co and B Co
For A Co, it is a national champion that operates in a matured market. It is a cash cow which has a track record of paying out 80% of its earnings to shareholders in dividends and keeping about 20% of its earnings for plant repairs and maintenance purposes. At present, A Co’s details are:
Stock Price = $20.00
Earnings per Share (EPS) = $1.00
P/E Ratio = 20
Dividends per Share (DPS) = $0.80 (80% of $1.00)
EPS Growth Rate = 0%
For B Co, it is a global powerhouse. Like A Co, it is also a cash cow. But unlike A Co, B Co invests 100% of its earnings back into the business, expanding its moat (dominance). As a result, B Co’s EPS is growing at a rate of 15% per annum. At present, B Co’s details are:
Stock Price = $30.00
Earnings per Share (EPS) = $1.00
P/E Ratio = 30
Dividends per Share (DPS) = $0.00
EPS Growth Rate = 15%
Method 1 – Comparing Current PE with Historical PE
This method involves comparing their P/E Ratios with their historical P/E Ratios (10 years).
Here is the rationale.
Let’s say, in Year 0, you bought an apartment for $480,000 for investment.
You secured a tenant that pays $2,000 a month / $24,000 a year in rent.
So, your rental yield is 5% per annum.
10 years later, you manage to raise the rent to $2,500 a month / $30,000 a year in rent.
If investors continue to expect 5% in annual rental yield, what’s the value of your apartment?
Answer = $600,000.
What went up in those 10 years? Answer = Property Price. (Price)
What was the driver for its appreciation? Answer = Rental Income. (Earnings)
What had remained constant in those 8 years? Answer = Expected Rental Yield (Valuation)
This rationale (or concept) can be applied on stocks.
Referring back to A Co and B Co.
Let’s say, over the past 10 years, A Co’s shares were trading on average at a P/E Ratio of 25. That is also the same with B Co.
At current P/E Ratio of 20, A Co is undervalued as it is below its historical average of 25.
As for B Co, it is overvalued as its P/E Ratio of 30 is above its historical average of 25.
So, is that it? Is A Co definitely a winner when compared to B Co?
Let’s dive deeper.
What Are We Investing For?
Here, it is helpful to revisit our purposes for investing in stocks.
It is primarily to achieve sustainable capital growth in the long run.
Of course, in the meantime, it is always nice to receive dividends. Hopefully, they will grow too.
Hence ultimately, growth is what we are looking for.
Such is achieved more sustainably with growth in earnings per share (EPS), which is contributed by long-term sales growth, earnings growth and share reduction. Companies that could deliver such financial results often have competitive advantages, which are often known as moats.
So, it is fundamentals that drive long-term growth, be it capital growth or dividend growth.
Method 2 – Comparing PE with EPS Growth
With this in mind, it is crucial to assess the fundamental qualities of a stock before investing.
By factoring in growth, we discover that the payback period for investing in B Co is shorter. This is even if its P/E Ratio is higher than A Co.
Here are the maths.
For A Co, its payback period is 20 years.
Investors who opt for A Co shall invest $20 to earn $1 every year. Since its EPS doesn’t grow, the shareholders shall earn $20 by holding onto A Co for 20 years.
But, what about B Co?
In Year 0, its EPS is $1.00.
In Year 1, its EPS is $1.15 as it grows at a rate of 15% per annum.
In Year 2, its EPS would grow further to $1.32.
In Year 3, its EPS would grow further to $1.52. You can generate a table as follows:
Investors who opt B Co may (in a glance) pay a higher PE for its shares (PE = 30).
But, their payback period is between 11 to 12 years, a lot faster than A Co.
Based on this perspective, B Co is more attractive than A Co despite having a higher P/E Ratio.
Notes:
A Co – Invested at $20 (PE = 20). Earned back in 20 years.
B Co – Invested at $30 (PE = 30). Earned back in 11-12 years.
So, do we use Method 2 over Method 1?
Well, not entirely.
Personally, I use both depending on situations and context.
Let’s say, I’m considering an investment into a growth stock. I’ll use Method 2 first to evaluate its investment attractiveness. Then, I’ll use Method 1 as a guide on determining my entry prices. As an investor, I’ll still prefer to invest when its current P/E Ratio is either below or (if above, close to / not too far away) from its historical long-term P/E Ratio.
But, if I want to invest in a pure-breed dividend stock, I’ll only use Method 1.
All in all, the first priority is on EPS growth.
The second priority is on its valuation.
Conclusion:
There are a few conclusions to this:
1. A low P/E Ratio does not necessarily mean that a stock is an attractive buy.
2. The context (business growth & fundamentals) is important.
3. Growth > Valuation.
4. A stock with a high P/E Ratio can be attractive as an investment if its growth rate is solid.
At the end, the focus is to shift from “buy cheap” to “buy growth at reasonable prices”.
