Valuation with Price-Earnings Ratio: A case study on Pintaras Jaya

From the response on my article in the appended link below, everybody seems to agree that Pintaras is indeed a good company. It has high return of capital, good quality earnings as shown in cash flows and plenty of excess cash in its balance sheet. But more importantly, is it worth investing?

http://klse.i3investor.com/blogs/kcchongnz/46408.jsp

Remember that you could purchase the best stock in the world, but if you buy it at a lofty premium, it is a bad investment.

Most investors, including analysts, use the price-earnings ratio (P/E) to determine if a stock is cheap. It is the quickest and easiest way to value a company and to determine what a company's stock should be worth. Generally, a company with a high P/E is expensive when compared with one of low P/E. Here, we will use this P/E ratio to evaluate if Pintaras is cheap and worth investing.

Table 1 below is the Income Statement for Pintaras for the year ended 30^th June 2013. I have adjusted the statement a little for my ease of usage for my future presentation. Basically I have separated what I considered “ordinary income” from construction and metal can fabrication from my own definition of non-ordinary income from investment and interest income.

Table 1: Income statement for year ended 30^th June 2013

Pintaras earned 52.3m in 2013. With the number of shares outstanding at 160m, EPS comes to 33 sen. And at a closing price of RM2.98 on 14^th February 2014, the P/E ratio is 9.1 as shown. So is a P/E of 9.1 high or low for Pintaras?

If you flip the P/E ratio over, it becomes E/P, or earnings yield. It shows your return for the price paid which you can compare to alternative investment such as bank deposit, property investment or other forms of investments. The earnings yield of Pintaras is hence equal to 11%. So are you happy with the 7%-8% of premium over the bank deposit rate of 3%-4%?

Secondly, you have to understand that different industries have different P/E ratio ranges that are considered "normal". Table 2 below shows the P/E ratios of some construction companies based on their historical earnings and closing prices as on 14^th February 2014.

Table 2: Share prices of some construction companies and their P/E ratio

When you compare with Crest Builder, WCT and Kimlun, Pintaras’s P/E ratio of 9.1 is relatively high, or more expensive; whereas if compared with HSL, Gamuda or IJM, Pintaras would appear to be relatively cheap. The share price of Pintaras would be reasonable if compared with the average P/E of the whole group of 11.0. So is the price of Pintaras at RM2.98 high or low?

Thirdly in the above comparison, the companies are not equal in many aspects in terms of performance, efficiencies, capital structure (how much equity and debts is used), stability of earnings and cash flow, growth prospects, sizes, financial strength etc. Clearly a company with a higher growth expectation, a healthier balance sheet, more stable earnings etc should be accorded higher P/E ratios. This leads to our next valuation model using absolute P/E ratio to take care of all these.

Katsenelson’s Absolute PE

For those who are interested in this valuation method, you can refer to the following link:

http://klse.i3investor.com/blogs/kianweiaritcles/36512.jsp

This model derives the intrinsic value of the stock based on the following five conditions.

1. Earnings growth rate
2. Dividend yield
3. Business risk
4. Financial risk
5. and earnings visibility

The model first starts with a no growth P/E ratio of 8 (original), or an earnings yield of about 12%, and then adjusted according to its growth rate and dividend yield to derive a basic P/E. The adjustment can be extracted from Table 3 below:

Table 3: Adjusted P/E ratio

Pintaras’s revenue and net profit has been growing at 9% and 27% respectively for the last 7 years. But as construction is cyclic, it is prudent to assume that the expected growth in the future to be zero. Basic PE for Pintaras with a conservative expected growth rate of 0% and a dividend yield of 4.3% is,

Basic PE = 8 + 0.65*0.0 + 4.3 = 12.3

Business risk:  PINTARAS’s business has high efficiencies with high return of assets of 16% and high return of capital of 35%. It has quite stable and high operating profit margins of more than 30%. Its cash flow from operations is also stable, about the same as its net income. It has stable and high free cash flow every year, averaging more than 12% of revenue. Cash return (FCF/IC) is also great at 30%. Hence there may a good moat in its business. An arbitrary 10% discount is applied to its business risk.

Financial risk: PINTARAS has a very healthy balance sheet with net cash per share of RM1 and no debt. Hence an arbitrary discount of 10% is applied to the financial risk.

Earnings visibility: Again, as construction is cyclic, we assume the earnings for the future is flat. Hence neither premium nor discount is applied to earnings visibility as a conservative assumption.

Hence the absolute PE for PINTARAS is:

Fair Value P/E = Basic PE x [1 + (1 - Business Risk)] x [1 + (1 - Financial Risk)] x [1 + (1 - Earnings Visibility)]

Fair value P/E = 12.3* [1+(1-90%)] *[1+(1-90%)] * [1+(1-100%)] = 14.9

Earnings per share 2013= 33 sen

Fair value of Pintaras= 14.9*0.33 = RM4.91

Margin of safety = (4.91-2.98)/4.91 = 39%.

Hence from the absolute P/E ratio valuation perspective, Pintaras is clearly way undervalued with a wide margin of safety.

K C Chong (15th February 2014, 11.17pm)