Great expectations and the P/E ratio
The Finance and Investment Column
Stabroek News
July 9, 2004
This column provides informative commentary on financial matters and is written by Patrick van Beek, Managing Proprietor of Caribbean Actuarial & Financial Services.
I was reading the financial press while on vacation in the UK and was struck by the table of average P/E ratios for various markets around the world. Having been close to only the Guyanese market for the past year, I had come to expect P/E ratios that were less than 10 as the norm. It was with some surprise I saw that Guyana's average P/E ratio of around 7.5 is well below the average elsewhere.
The P/E, or price earnings ratio, is a simple measure of how cheap or expensive a stock looks. Because companies have different capital structures, to say that one share is expensive relative to another, purely based on price, is nonsensical. A classic example would be two identical companies, one with twice as many shares in issue. If the company with fewer shares was twice the price it would not be more expensive. The price would be exactly consistent with the company with twice as many shares. Earnings per share reflects the amount of profit generated by the company for each share in issue. A company with fewer shares will have a higher earnings per share. By dividing share price by earnings per shares you get the price earnings or P/E ratio - a figure which broadly can be thought of as "how many years of earnings are required to cover the price paid for the share." Whether one share is expensive relative to another can now be readily seen by comparing their P/E ratios and the stock with the higher P/E ratio is the one people are paid to "pay more" for.
Of course things are not always equal, otherwise share purchase and sale decisions for all stocks could be made purely by buying when a P/E ratio fell below a certain level and selling when it moved above a certain level. In fact the price at which shares clear in the market reflects the price at which buyers and sellers reach a consensus on what they are prepared to pay and receive respectively. In deep liquid markets the price can be viewed as the equilibrium or average opinion of buyers and sellers as to what shares are worth.
A company trading at a certain P/E ratio can be thought of as the market consensus as to how many times earnings one should pay for the share. A quick scan down a list of P/E ratios for different stocks in any market will reveal widely different P/E ratios. Even in Guyana there is a range of 3.8 to 10.4 as of July 2. One might well ask why investors are prepared to pay and receive such a wide multiple of earnings. The answer lies in the fact that the market expects the earnings of different stocks to grow at different rates. If you never expect earnings to change you might be happy to pay 5 times earnings for a particular stock. You would be reasonably certain that you could sell the stock and it would not have moved much from its current price, unless there actually was a change in the consensus view about earnings. If you expected earnings to double each year for the foreseeable future, then you might be prepared to pay a multiple of even 100 times earnings!
High P/E ratios should be expected in companies that are likely to see significant growth. But what if established "blue chips" are seeing stocks trading on high multiples of earnings? The market may be pricing in significant amounts of growth just to achieve an acceptable rate of return. One way of analysing the levels of growth implicit in the price of a stock is to use a simple stock valuation model, such as the discounted dividend model. This is an extremely crude model and its limitations include a host of simplifying assumptions which are almost certainly not borne out in practice. Arguably the two greatest limitations are the assumption of constant rate of growth applying to earnings, and that the payout ratio (the proportion of earnings paid out as dividends) remains the same. However, even with the limitations of the model the insights gained can be quite revealing.
By applying the model to the stocks currently trading on the GASCI stock exchange one can see the rates of growth built into share prices in order to justify a total expected return of 15% at current earnings multiples.
If some of these growth rates seem unusually high or low this could be a sign that the total expected return of 15% is unreasonable. Different stocks will achieve a different overall rate of return simply because of their inherent risk - the more risk there is perceived to be, then the higher the rate of return required in order to compensate for that risk. If you believe that a return of 15% on Guyanese equities is to be expected then half of these companies will require consistent growth rates in excess of 10% to support current valuations. If growth does not live up to these expectations then the likely outcome is that the P/E ratio would fall until growth expectations can be met. In the market, the mechanism by which this occurs is that unhappy shareholders will sell their stock thereby pushing the price down. In the absence of any change in earnings the P/E will also be reduced.
With all but one of the P/Es above lying below 10 it is unlikely that there is much pressure being placed on companies in Guyana to grow earnings at rates which are unsustainable in the long run. Looking farther a field it is not difficult to find companies whose valuations are considerably more buoyant. A classic example would be Enron. In February of 2001, Enron was trading at a multiple of 48 times earnings with a payout ratio of 34%. In order to justify this multiple the market required in excess of 14% growth in earnings to justify it. Although 1st quarter earnings were up 14.6% the next quarter earnings fell 4.3%. Together with the worries about disclosure this helped to drive the stock down 45.3% and by the end of August the stock was trading at a P/E of 20.86.
As of July 6, 2004, software giant Microsoft was trading at a multiple of earnings of 42, while their payout ratio is 35%. Given its massive market share in the operating system market, continued growth in earnings would not be unexpected. One must wonder though what a valuation of almost 6 times that of the average share in Guyana is saying. Perhaps it just reflects an extremely pessimistic outlook for growth in Guyana.