Cotter On Investing - John Cotter

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of 100p and EPS of 50p; it therefore has a PE of 2 (100/50); it would take 2 years for the earnings to cover the price paid for the share.

      All things being equal (which, admittedly, they rarely are in investing) an investor would prefer to buy company B rather than company A because the earnings will pay for the price paid in just two (instead of five) years.

      One way to think of this is as an investor buying the whole company. In the case of company A, it will take five years for the company’s earnings to repay the price paid to buy the company, But for company B it will only take two years. Which company would you prefer to buy?

      In this context, company B is called cheaper than company A because its PE ratio is lower.

      Unfortunately, nothing in life is as simple as you would like it to be and few things are as difficult as keeping things simple. Let’s first of all see how this position becomes more confused before hopefully I reach a simple and logical conclusion that will help guide your future use of the PE.

      Different types of PE

      When calculating PE ratios in real life, it is easy to find a company’s share price, but what figure should we use for EPS? For example, should we use the company’s earnings from last year or its forecast earnings for this year? Because of the different values of EPS that can be used, there are three basic types of PE ratio. All are based on the current price, but one is based on previous earnings, one is based on forecast earnings and one is based on average earnings.

      1 Trailing PE: This is based on the actual earnings for the previous 12 months and is sometimes referred to as the historic PE.

      2 Cyclically adjusted PE: This uses earnings averaged over periods as long as ten years; often referred to by its acronym CAPE.

      3 Forward PE: This is based on the forecast earnings for the coming 12 months and is often referred to as the forecast PE.

      The following table gives some sample real-life data for trailing and forecast PEs:

Company Share price Trailing EPS Trailing PE Forecast EPS Forecast PE
ARM Holdings 545 6.44 84.6 9.96 54.7
Aviva 434 50.40 8.6 64.55 6.7
Severn Trent 1441 130.64 11.0 92.56 15.6
Tesco 388.5 26.29 14.8 32.72 11.9

      For example, in the previous 12 months Tesco had an earnings per share of 26.29p, and at the time of writing its share was 388.5p; therefore its trailing PE was 14.8 (388.5/26.29). However, for the coming 12 months Tesco has a forecast EPS of 32.72p, which gives it a forecast PE of 11.9 (388.5/32.75).

       So which is best?

      Different people have different views. The trailing PE is one that is quoted most often in the financial press. The main advantage of this method is that you are dealing with facts, not forecasts. The CAPE has had, and still has, its followers; some notable ones include Benjamin Graham and Robert Shiller. The advantage of the CAPE is that it eradicates the possibility of the ratio being distorted by one year’s figures. A moving average over a minimum of five years should mean that the sample period includes at least one complete economic cycle. And this measure is supported by the logic that company and index ratings will in time revert to their mean.

      While both of the preceding have merit and cannot be dismissed lightly, my first point of reference will always be the one year forward PE.

      Although the trailing PE is based on verified figures, you don’t drive a car by looking in your rear view mirror, therefore I prefer this year’s forecasts to last year’s facts. The same comment applies to the CAPE but even more so. There is no doubt the CAPE will eradicate the chance of one set of figures giving a misleading reading, and although CAPE may be ideal for long-term financial studies, I cannot accept that earnings figures that could stretch back over a decade ago should play a part in tomorrow’s investment decision. The market itself is a forward looking animal. It’s a barometer, not a thermometer, and will always discount ahead. It therefore makes sense to use a measure that does the same.

      Interpretation of the PE

      As mentioned above, the PE is a measure of the value placed on a company by the market. If investors like a company they will buy the shares, which will drive the share price up, which will result in a higher PE. This is a simple function of the calculation of the PE. Remember, the formula is:

      PE ratio = share price/earnings per share

      If the earnings per share stay the same but the share price increases, this results in a higher calculated PE.

      Conversely, if investors dislike a company they will sell the shares, which will drive the share price down, which will result in a lower PE.

      Companies with high PEs are often referred to as being highly rated by the market, while companies with low PEs are often referred to as being lowly rated by the market.

       But the big question is: what level is considered high (or low) for a PE? For example, is a PE of 20x considered high?

      There is no short answer to that question. Different people interpret the PE differently.

      For example, growth investors may regard a PE of 30x as not unreasonable if a company is expected to grow strongly. Whereas a value investor (like Warren Buffett) prefer companies with low PEs. It is not surprising that Buffett never invests in technology companies (that often have high PEs).

      Personally, I align myself with Buffett and prefers companies with low PEs. A low PE shows that the stock is cheap relative to its earnings. We know that price and earnings are inextricably linked, which makes the low PE stock a safer proposition with a lower downside risk.

      Using the PE to compare stocks

      The absolute level of a share price tells us little about a company. Knowing that AstraZeneca has a share price of £28.74 and GlaxoSmithKline has a share price of £11.70 tells us nothing about the absolute or relative merits of these two companies. But comparing their PEs can be useful. In this case, AstraZeneca has a forward PE of 7.1x, while GlaxoSmithKline has a forward PE of 9x. This tells us that the market places a higher rating on GlaxoSmithKline than AstraZeneca. So, while its share price may be nominally cheaper, GlaxoSmithKline shares are regarded as more expensive than those of AstraZeneca.

      The job of the investor is to consider whether the market has got it right. If an investor believes that the prospects for AstraZeneca are as good (or even better) than GlaxoSmithKline, then he would regard AstraZeneca as currently being good value relative to GlaxoSmithKline.

      Examples

      Let me demonstrate how I use the PE to assess stocks.

      The following table lists some stocks and their forecast PEs. For comparison,

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