Investors love short cuts. If the aim is to buy undervalued businesses, many will just focus on buying stocks with a low price-to-earnings (P/E) ratio. It’s not a method I’d suggest, but it’s one that doesn’t take a lot of time or energy to put into practice.
First, let’s see why investors prefer low P/Es to high P/Es.
Let’s say you have a choice of buying Stock X with a P/E of 10 or stock Y with a P/E of 30. You can either pay $10 for every $1 of earnings Stock X produces or you can pay $30 for every $1 of earnings Stock Y produces.
If we assume these companies are identical, then Stock X would be the obvious choice. You’re paying less for the same amount of earnings.
But, of course, these stocks are not identical. Stock Y has a high P/E because investors believe they can grow earnings at a higher rate than Stock X.
But how can you tell if a P/E is too high? It would be foolish to only stick to stocks trading at 10-times earnings and no higher. You’ll end up passing on highly-attractive investments simply because they’re slightly more expensive.
I’m not saying you should go out and buy stocks trading at 50- or 100-times earnings. But you shouldn’t limit yourself when it comes to investing.
OK, but how can you determine if a stock with a high P/E is a ‘growth’ or ‘hype’ stock?
High growth or high hype?
REA Group Ltd [ASX:REA], owner of realestate.com.au, has been a great investment for shareholders. This year alone the stock is up 23%. And over the last five years, REA is up 403%.
Throughout that time, REA has traded at a P/E of 20 or more. At one point in 2014, the stock was trading at a P/E of more than 60-times earnings. Currently, REA is trading around 34-times earnings, which does seem a bit high.
But how can you know it’s high? Will the stock continue to post triple-digit returns in the next five years? Or will growth significantly slow down from here?
One thing we could look at is the company’s return on invested capital (ROIC). This is the returns a business can generate on the money it actively invests. This includes debt and equity the company has on its balance sheet. So, a high ROIC means a business has high-return-generating activities it can readily invest into.
From FY2011–16, REA Group averaged a ROIC of around 34%. This means, for every $1 invested, REA generated 34 cents in earnings. If we further assume REA reinvest 60% of earnings back into the business, they could theoretically improve their earnings power by 20.4% each year (0.34*0.6).
That means, based on our assumptions, REA could improve earnings per share from $1.81 per share in 2017 to $4.58 per share by 2022. But there’s still a missing piece of the puzzle. What will investors be willing to pay for REA in five years’ time? 10, 20, maybe 30-times earnings?
Below is a table of what REA’s share price might be based on our back-of-the-envelope maths in five years’ time.
|Five years from now||Potential Price||Potential Return|
|P/E 10||$45.8 per share||-33%|
|P/E 15||$68.7 per share||0.04%|
|P/E 20||$91.6 per share||34%|
|P/E 25||$114.5 per share||67.37%|
|P/E 30||$137.4 per share||100.9%|
Remember your assumptions
I’d suggest you not base your investment decisions on the simplified maths above. Instead, think of it as a confidence boost. Use extremely conservative estimates and plan for worst-case scenario. But always remember the assumptions you’re making.
For example, in the case above, we assumed REA would improve EPS on average by 20.4%. Is this likely? Maybe…but it’s best to ratchet your estimates down. For example, we might assume that REA Group will only grow EPS by 15% instead of 20.4% each year, to be on the safe side.
You have to ask yourself, is this situation likely? Any investment you make should have a high degree of certainty. Even if the best outcome doesn’t happen, you should still be confident in a potential investment.
Junior Analyst, Money Morning
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