Understanding PE

Ricky Yeo

Publish date: Wed, 23 Dec 2015, 06:04 PM

	PE is the most widely used shorthand ratio by investors. We use it to arrive at a target price or determine if a stock is under/overvalued. Because of it’s popularity due to it’s simplicity, many are stretching the practicability of PE too far, misusing and abusing it. I list up a few things below to help you better understand PE.

	It is just a tool

	PE is just one of the easiest tool out there to use. Everyone use it because it is easy to communicate with other investors. If you start talking about Sharpe, people’s reaction will be like ‘Huh?’.

	Since PE is just a tool, that means sometimes it is wise not to use it. Everything is a nail to the man with a hammer. If you only have hammer in your toolbox, you will use the hammer to solve every problem. Same goes for PE. That will eventually lead you to trouble.

	Some obvious ones are you shouldn’t use PE on cyclical industry (i.e. auto), or perhaps even financial companies. The solution here is learn more. Have more tools in your toolbox.

	Use EV/EBIT (Enterprise Value/Earnings before Income Tax) instead

	If you need to add more tools then EV/EBIT should be the one to replace PE.

	PE stands for Price/Earnings, or Market Cap/Net Profit. PE can be misleading especially when companies have plenty of debts. Market Cap does not differentiate a company with net cash and another with net debt. Airasia Bhd market cap is 3.62b, but it’s EV is 12.04b, that’s mostly debt.

	You can google easily for EV/EBIT formula. But if you want a quick way to view a company’s EV/EBIT, go to google, type ‘Airasia Bhd EV/EBIT’. Search. Results will show up ‘AirAsia Bhd (XKLS:5099) EV/EBIT - GuruFocus.com’. There you have it. Gurufocus has all the ratios & figures. A very convenient website.

	Return on Equity matters

	You will often see people estimating EPS for the next 2-3 quarters, whack a PE 10 onto it and there goes the target price. Boy if only it’s that easy.

	Glove stocks are good example. All of their PE breaking above 20 and mostly inching 30. That’s because investors have high expectation that they will register solid profit growth and good return for shareholders. In short, investors expect them to add value over the long run.

	What does it mean add value? Adding value means companies can earn a return in excess of cost of capital. Cost of capital (CoC) consist of a mixture of debts and equity.

	Cost of debts is straight forward. Companies borrow money from banks to expand their business. The interest they are paying back to bank, 6-8% etc is the cost of borrowing.

	Cost of equity is a bit more complicated. But think it this way. If an investor is placing his money in FD for 3% per annum, how much return do you need to give this investor in order to have him withdraw all his FD and invest in your stock? The rule of thumb is that it will always higher than cost of debts. 9-11% is a ballpark. For me I just use 10% for CoC.

	ROE as I explained last time is the % of return you earn from a business compare to the money you throw in. So..

	If ROE is higher than CoC = Add value

	If ROE is lower than CoC = Destroy value

	Now the fun part. If ROE is below CoC, what happened to the PE? It goes down! If the company is adding more and more value to investors, it is common sense for PE to go up. But if it is destroying value the PE will get lower and lower.

	Do not assume that just because profit is growing, PE will naturally rise to 10. If ROE is below CoC, it is actually the opposite. If a company is throwing more money that outpace the growth of profit, ROE will continue to drop. No one wants to invest in this kind of business. Why would the company deserve a PE of 10?

	https://www.facebook.com/notes/malaysia-contrarian-investing/understanding-pe/1653414924913400

Discussions

2 people like this. Showing 6 of 6 comments

Willie Ong

Hi JT Yeo,

Newbie here. Would like to know where can i get the Cost of Capital (CoC)? Is there a formula for it?
Thanks.

2016-03-10 17:52

Probability

JT Yeo…nice sharing…but as a mental exercise..i would like to present my view:
I think P/E is the standard expectation of the market rather fixed around ~ 10 and the P/B is the variable part based on the ROE = E/B

To put it in a formula:

P/B = (P/E) x 1/ (E/B)
= PE over ROE

i.e using PE of 10, P/B = 10 x ROE…meaning Mcap over Book value is purely dependent on the actual ‘true ROE’…i.e based on the true Earnings.
PE of 10…is basically at that level coz.. the inverse value..i.e, E/P has to be above that minimum level 'the cost of capital of 10'….if the market cost of capital goes higher…you would expect a lower PE.

Now..why some deserve a higher PE?
I think that’s purely due to E-arnings growth…meaning the ‘true ROE’ is way much higher than from its visible history or from the near future… a much higher true ROE will obviously give a much higher current P/E…as the real E is much bigger in the future.

2016-03-10 18:36

Probability

you can actually use the NPV of future E-arnings as and indicator of the true value of the E...to get an idea why some has higher P/(E-present).

2016-03-10 18:38

Probability

Sorry the formula is this:

P/B = (P/E) x (E/B)
= PE X ROE

getting old already..

2016-03-10 19:10

soojinhou

Thank you for the refresher course.

2016-03-10 19:25

3iii

EV = market value of common stock + market value of preferred equity + minority interest + market value of debt - cash and cash equivalents (investments).

Using EV as a enterprise multiple, you should divide EV by EBITDA.
Enterprise multiple = EV/Ebitda

Prof. Domodaran of NYU, the expert on valuation, stresses on this point relentlessly.

Read more: Enterprise Value (EV) Definition | Investopedia http://www.investopedia.com/terms/e/enterprisevalue.asp#ixzz42UzeH0NG

2016-03-10 19:36

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