Price-to-earnings ratio and its use as an investment strategy kcchongnz

Posted by Pika Chan > Oct 30, 2014 09:44 PM | Report Abuse
kcchongnz, your article never fails to inspire me and educate the ignorant vast majority, you are one of the truly shining sifu in i3investor .

Pika,
Thanks for your kind words, and many others too which I did not express for certain reasons in this type of forum to avoid misunderstanding. You are expert in your own field too. That is something I need to learn from you too.

Hope to meet up with you.

2014-10-31 05:38

Posted by Alphabeta > Oct 30, 2014 10:14 PM | Report Abuse
kcchongnz, what is your view of using PEG (<1) as a yardstick for valuation. Growth rate is based on the average of past 5 years sustainable growth rate formula [ROE x(1-Div Payout)].
Another ratio is the incremental net earning (PATAMI)over the incremental average owner equity. This is to check on the incremental return on equity reinvested.
Is the operation cash flow over PATAMI a good indicator on earning quality?

Alphabeta, nice to hear from you again. You are a good fundamental investor yourself. But since you asked, I will try to give my two sen.
PEG popularized by Peter Lynch in his book “One Up On Wall Street”, has been a very popular investing metric before the turn of the Century. Good book to read. In general, if a stock is trading at a PEG of less than 1, it is cheap. For example a stock trading at a PE of 10, has an expected rate of growth of 10%, its PEG is 1. Go buy it.

But let us refer to this report by HLG below.

http://klse.i3investor.com/blogs/kcchongnz/62293.jsp

HLG “KNM - Too Cheap to Ignore!”

[At current share price of RM0.745, KNM is only trading at 8.8x FY15 P/E despite strong earnings growth prospect (CAGR of 55% from FY14-FY16).]

What is the PEG of KNM following the metrics given by HLG?
PEG = 8.8/55 = 0.16

HLG says KNM should worth 6.3 times more of its present price, or
fair value of KNM = 6.3* 74.5 sen = 4.65

Go buy loads of it as long as it is below RM4.00!

Ok you cap your growth rate at [ROE x(1-Div Payout)].

Then g for KNM = 4%*50% = 2%

I remember General Lee said a few years ago he will distribute 50% of the earnings

Then PEG =8.8/2 = 4.4

So KNM is 4.4 times overvalued than its present price

Fair value = 7.45/4.4 = 17 sen.

So which one is correct, 4.65 or 0.17?

Take another example of a company I wrote about, Uchi Tech.

http://klse.i3investor.com/blogs/kcchongnz/62058.jsp

It earned 10.3 sen last year and paid out all its earnings as dividend. So growth = 0, and value of Uchi = 0?

PATAMI? I don’t know about it. But reading what you wrote, it doesn’t seem to be a valuation metric.

2014-10-31 07:03

Posted by gohcheehoh > Oct 31, 2014 12:25 AM | Report Abuse

Gd sharing. My personal thought of picking those safe bet counter to invest.

"All this involve sizeable homework. Have fun... "

Good sharing of extra filters. I can't see how you can't succeed in your investment. Good work. And no such thing as gain without pain.

2014-10-31 09:20

kcchongnz, thanks for your reply. I like to read your articles whenever i am free. PATAMI is a short form for owner's earning. Profit after tax after minority interests. I read this valuation method in Share Fundamental website. It is using this a check on earning quality (some company like to use financial engineering to prop up profit but operating cash flow is poor, for example sudden jump on debtor or inventory level etc.)

I would like to seek your view on Intrinsic Value, “Intrinsic value is the present value of all cash that will be distributed from now until judgment day”.

One of my measurement of Intrinsic Value is based on applying a discounting factor (my expected return) on total shareholder return (TSR). In order to project future cash flow on TSR, i need to ascertain over the passed 5 years the P/E ratio, sustainable growth and dividend payout %. I will get the average of these three parameters for my TSR projection and discounted with my expected return (minimum 10%)

TSR Projection

A> EPS x sustainable growth (average growth rate)
B> then multiply with average P/E to get the future market price
C> Apply average dividend payout % on the projected EPS and accumulate this over the year.
D> Add B+C = TSR
E> Apply the discounted factor on D to get the present market price.

kcchongnz, is there any flaw on this calculation? In current scenario, very difficult to select stock with the desired price using this method unless i lower expected return or increase the growth rate on positive news flow and better quarterly result.

Will appreciation your comments on room for improvement.

2014-10-31 10:04

I would prefer a liberal approach on valuation whereby Different methods of Valuation is applied so much so that different aspects of business operation is examined and inspected to generate a Fair range of Pricing in different circumstances.

2014-10-31 21:33

This is consistent with the manner price is traded most of the time which is a fair Range.

And with certain catalyst which will impact the business operation, so the price will either break up or break down.

2014-10-31 22:06

There is another approach mentioned in "Intelligent Investor" for defensive investor using P/E x PBV < 22.5. The logic of this approach not to pay for P/E exceeding 15 and PBV <= 1.5.

2014-10-31 22:13

good then we would surely try to examine the Business and valuation from different angles and perspectives. Knowing that no business is the same and evolving, method could be slightly different.

End of Day, what is your confidence level and your competency and how well you know the Business is very important.

2014-10-31 23:27

i would fully agree that Management needs to strike a good balance of Dividend payout, retained earning and capital reinvestment.

Again it depends on the Growth strategy and Business cycle.

2014-10-31 23:50

Like it Or not, i perceive lots of small cap might fail in their Growth stage and Down Business cycle.

So sometimes it will be frustrating to analyze them too much as their operations has yet to gain footings.

And certain Business is Not easy to understand at all.

So I think we can Only analyze the Business that we can understand and which are more sizable and stable.

Having said that we are shunning ourselves from the more upside from small cap. To strike a good balance, it is worth to look at mid cap which has good chance to become Blue Chip.

2014-11-01 00:05

Alphabeta kcchongnz,
I would like to seek your view on Intrinsic Value, “Intrinsic value is the present value of all cash that will be distributed from now until judgment day”.

One of my measurement of Intrinsic Value is based on applying a discounting factor (my expected return) on total shareholder return (TSR). In order to project future cash flow on TSR, i need to ascertain over the passed 5 years the P/E ratio, sustainable growth and dividend payout %. I will get the average of these three parameters for my TSR projection and discounted with my expected return (minimum 10%)

kcchongnz, is there any flaw on this calculation? In current scenario, very difficult to select stock with the desired price using this method unless i lower expected return or increase the growth rate on positive news flow and better quarterly result.

Will appreciation your comments on room for improvement.

Alphabeta,

You are basically using a hybrid method to get your intrinsic value, or specifically more of a relative valuation like a PE ratio, EV/Ebit that sort of valuation because you are replying most part of your cash flow from the expected price of the share at certain future date. The cash flow from the annual dividends just make up a small part of your intrinsic value. This is not exactly like what your opening statement mentioning about what intrinsic value is.

This valuation method is not favoured by those investment guru such as Seth Klarman.

2014-11-01 11:44

kc, TSR is based on the capital gain and dividend yield. The former is a product future market price less the entry price. The assumptions here are the P/E will prevail and the sustainable earning growth rate will propel the market price into the future.

If you disposed the share after 5 or 10 years later, the total proceeds from disposal (say X) plus cumulative dividend received (say Y) minus initial price (P) will give a compounding return of 10%. Frankly speaking, 5% is required to take care of inflation rate and transaction costs. The real return is only 5%.

P*(1+10%)^5=X+Y
P = (X+Y)/(1+1.1)^5

These depend on a> sustainable growth rate ROE*(1-dividend payout), b> dividend payout ratio, c> the current average P/E continue to be prevailed into future.

2014-11-01 14:21

Like stockoperator mentioned earlier, beside this mechanical calculation as a guide, we need to look for other indicators which is the key drivers for future top -line and earning growth. Its current financial health etc.

2014-11-01 14:31

sorry, correction P=(X+Y)/(1.1)^5

2014-11-01 14:38

Alphabeta,

Let me repeat my opinion on your valuation method.

You are basically using a hybrid method to get your intrinsic value, or specifically more of a relative valuation like a PE ratio, EV/Ebit that sort of valuation because you are replying most part of your cash flow from the expected price of the share at certain future date. The cash flow from the annual dividends just make up a small part of your intrinsic value. This is not exactly like what your opening statement mentioning about what intrinsic value is.

This valuation method is not favoured by those investment guru such as Seth Klarman.

2014-11-01 16:57

Posted by Alphabeta > Oct 31, 2014 10:13 PM | Report Abuse

There is another approach mentioned in "Intelligent Investor" for defensive investor using P/E x PBV < 22.5. The logic of this approach not to pay for P/E exceeding 15 and PBV <= 1.5.

Alphabeta, yes that is Graham number, don't pay for PE ratio and P/B more than 15 and 1.5 respectively. Good guideline for most people.

But is PE 15 and P/B 1.5 really that cheap? It depends actually. Other things may be more important, such as the difference in ROE, ROIC, enterprise value etc.

2014-11-01 17:02

kc, thanks for your comments and recommendation. I will find time to read Seth Klarman principle on value investing.

One last question, when computing P/E ratio. Is it better to used volume weighted average price of a stock "VWAP" or the year end price.

For Uchitec, its VWAP for FYE 31/12/13 is 1.24 (P/E 12.0) whereas the adjusted year end price is 1.37 (P/E 13.2). Normally i will download from Yahoo Finance for the daily data to compute the VWAP.

2014-11-01 17:31

Alphabeta,

When I look at a stock to see if it is worthwhile to invest or not, I am only concern about what it its price offered, and now. Why do you bother about whether it is VWAP or what, unless you are trying to do a research. Those PE ratio stated in my article are by the publication of Share Investment, a monthly publication sold in the book shop. Exactly which price in the month of October 2009 they base on I don't know, but it doesn't affect my conclusion.

The more important is the earnings, which earnings? Forecast earnings, ttm, historical or which one?. They all have their own merits and shortcoming as discussed in the article.

2014-11-01 18:04

kc, you are right. Getting the right EPS, DPs is vital especially when there is a price adjustment events like bonus issue and share split or any price sensitivity event subsequent to year end may affect the EPS and P/E calculation.

I find that even in I3Investor, the current price has changed after announcement of bonus issue but the EPS, DPS of past years remained the same which reflect wrong P/E and Dividend yield results.

The reason i am asking this is because i am using the past 5 years average P/E ratio to project the future price. Using VWAP will iron-out the volatility issue if i just use the year end price to compute P/E.

2014-11-01 21:06

Alphabeta,

"The reason i am asking this is because i am using the past 5 years average P/E ratio to project the future price. Using VWAP will iron-out the volatility issue if i just use the year end price to compute P/E."

Not sure how you can project future share price using PE ratio. You seem to deviate from your initial statement below:

“Intrinsic value is the present value of all cash that will be distributed from now until judgment day”.

2014-11-02 12:57

kc, will you be interested to evaluate this if i email a copy of the template to you. If it is a fruitless exercise, i would not want to continue to use this as a yardstick.

2014-11-02 13:09

Posted by sunztzhe > Oct 30, 2014 11:54 AM | Report Abuse

kcchongnz, Thanks for the superb write-up. Please advise the maximum debt equity ratio which you consider as healthy under current benign interest rate invironment. If interest rate is to double, what is the max debt equity ratio that you will consider as healthy mix?

Posted by sunztzhe > Oct 30, 2014 11:44 PM | Report Abuse

kcchongnz, thanks for your good response and I appreciate it very much. I agree with you that the most important info for the owner of the business and the banker as well is whether the cashflow generated can be consistent in paying off the interest and principal sum over a certain time period.

sunztzhe,

Welcome to the gang of the art of value investing. We really short of members here.

2014-11-02 13:21

KC is the Gangster head. And we are having Sunday morning recruitment drive.

2014-11-02 13:32

Dear Alpha,

In my opinion, knowing that it is a good business at fair price and Continue holding on to that Great Business knowing that it will be doing reasonably well in good times and bad times is good enough.

2014-11-02 14:25

sunztzhe

kc, Thanks and I feel honored at your invitation. In Value investing, it is always important to remember this...

"Wealth is the slave of a wise man but Wealth is the Master of a fool."

2014-11-02 14:33

Ops, forget one thing. Correct or Not, KC?

2014-11-02 14:36

Wah, see that it is Gold plated life member. Very shining.

2014-11-02 14:39

sunztzhe

erm...too shiny , can wear sun glasses..but sorry can't see the gold hahahahahaha

2014-11-02 15:05

You hear, Alpha?

Advice from our Gold plated life member: Take down all our analytic sunglasses and you will be able to see the Gold.

2014-11-02 15:14

Business in itself is our stronghold of Our Belief system. And investment is Acting on our Belief system. And we need to live out our Belief system. And most of the time it is Business as usual. Everything takes time and Time is on Our side.

2014-11-02 15:21

Posted by sunztzhe > Nov 2, 2014 02:33 PM | Report Abuse

"Wealth is the slave of a wise man but Wealth is the Master of a fool."

Indeed from the mouth of a wise man. It is conventional wisdom.

I know of somebody who already has immense wealth in the order of may be more than hundred million. But instead of just invest wisely, for example put half in fixed income and half in equity investing in good companies at reasonable price, and that is enough to provide a steady recurrence incomes for a few generations, give to charities and leave a legacy etc, prefers to borrow another hundred million to leverage up his investment and hope to make a lot more money. He only knows the power of leverage, but not the potential pitfall. There isn't any black swan in the world, is it?

http://klse.i3investor.com/blogs/kcchongnz/44344.jsp

That is not a very wise move in my opinion.

There are also a lot of people just work hard but not saving or invest, and whatever he saves is eroded by inflation. Or people instead of investing wisely following the proven value investing below, chose to speculate because they think that they are better than the insiders, syndicates and manipulators.

http://klse.i3investor.com/blogs/kcchongnz/59971.jsp

2014-11-02 15:51

Agreed, but i like to explore new idea. When there is doubt can seek others opinion. kc past recommendations have been quite enlightening, that's the reason why i sought his opinion when i have doubt.

2014-11-02 18:02

1007lsl

Post removed.Why?

2014-11-02 23:05

Friends, To win in the stock market must come with good feeling with yourself and with others.

2014-11-03 09:53

Chief

Thank you for sharing this great article, KC!

2014-11-03 23:28

Simon Ngiaw Wei Si

where can you get the PE ratios for each industry?

2015-09-29 03:21

Posted by Simon Ngiaw Wei Si > Sep 29, 2015 03:21 AM | Report Abuse
where can you get the PE ratios for each industry?

You may be able to get from Reuters Financials, Bloomberg, Yahoo Finance etc. for some US benchmarks. For local companies, I am not sure where you can get, maybe ask your brokers.

2015-09-29 03:53

anonboy

Good

2017-07-16 21:17

The above KC comment is shallow and miss some very important facts of PE investing loh...!!

Also KC comment of HEAD i wins and tail i don lose is highly misleading on users or PE investor loh...!!

KC cited counters like Xinguan, Msports agst Pe investment....but raider like to highlight if u take the test of xinguan on magic formula, Graham net net cash invesment and net net tangible assets...u also get the same positive results of positive buy loh...!!

Thus it is not a fair comment if u say Pe investor fail to detect a lemon when other value matrix also fail loh...!!

Why raider refute KC leh ??

Bcos this type comment...is very damaging to Ben Graham value investment theory of taking advantage of Mr market loh..!!

2017-07-16 21:39

Yes Pe investment has its drawback...but it has its advantage too loh....!!

Raider like says....the caution point is never never use...PE as a single basis of measurement loh...!!

U must supplement investment beside with Pe, cashflow, balance sheet, corporate governance etc loh...!!

Why china redchips stocks passed with flying colors on almost all fundamental test leh ??

Raider says if u faced with blatant extreme fraud and misrepresentation of the management who ignore any convention corporate governance and accounting & reporting standard and do not follow basic principle of ethic and law, how can u use any fundamental measurement like PE leh ??

The raider only see major fundamental investors did not buy into Xinguan, it is bcos of corporate governance and the company not consistently paying regular dividend despite of huge cash holding loh..!!

2017-07-16 21:52

In summary raider wants to reiterate PE is a good way of fundamental analysis, but it always read with other matrix including potential corporate governance.

In addition u also need to adjust the earnings to take into account of its exceptional and extraordinary items in order to derive its sustainable earnings mah...!!

Without normalising into sustainable earnings...u sometime get shock sendiri....wrong information loh...!!

2017-07-16 21:58

Thanks stockraider for your comments

I just write my reply in capital letters for the purpose of differentiating stockraider's comments and my comments.

Posted by stockraider > Jul 16, 2017 09:39 PM | Report Abuse

The above KC comment is shallow and miss some very important facts of PE investing loh...!!

Also KC comment of HEAD i wins and tail i don lose is highly misleading on users or PE investor loh...!!

THE ARTICLE IS ABOUT DESCRIBING INVESTING IN A BASKET OF LOW PE STOCKS AS A VIABLE INVESTING STRATEGY BASED ON STOCKS PUBLISHED IN A MAGAZINE 5 YEARS BEFORE THAT AS THE PORTFOLIO HAS HAD EXTRA-ORDINARY RETURN OVER THE BROAD MARKET. THERE WERE JUST FACTS. NOT SURE WHY YOU SAID MY COMMENT IS HIGHLY MISLEADING.

KC cited counters like Xinguan, Msports agst Pe investment....but raider like to highlight if u take the test of xinguan on magic formula, Graham net net cash invesment and net net tangible assets...u also get the same positive results of positive buy loh...!!

IN THE COMPUTATION OF RETURN OVER 5 YEARS, XINGGUAN, MSPORTS WERE IN NEGATIVE RETURN AND HENCE THE COMMENTS WERE, NOT ALL LOW PE RATIO STOCKS HAD GOOD RETURN, BUT SOME WERE BAD. THESE WERE FACTS AS COMPUTED BY ME, AND NOT MY COMMENTS.

Thus it is not a fair comment if u say Pe investor fail to detect a lemon when other value matrix also fail loh...!!

DID I SAY THIS?

Why raider refute KC leh ??

Bcos this type comment...is very damaging to Ben Graham value investment theory of taking advantage of Mr market loh..!!

ON THE CONTRARY, MY COMMENTS IN THE ARTICLE WERE

"This means you would have done very well investing in boring low PE stocks 5 years ago. The caveat is you must first avoid all red chips and companies with suspicious financial reports. One must know how to separate the chaff from the wheat, by close examination of the financial statements, especially the balance sheets and cash flow statements of those companies. Otherwise instead of making extra-ordinary return from investing in bursa, you end up losing your hard earned money speculating in lemons as shown in this link:"

2017-07-16 22:43

ON THE CONTRARY, MY COMMENTS IN THE ARTICLE WERE

"This means you would have done very well investing in boring low PE stocks 5 years ago. The caveat is you must first avoid all red chips and companies with suspicious financial reports. One must know how to separate the chaff from the wheat, by close examination of the financial statements, especially the balance sheets and cash flow statements of those companies. Otherwise instead of making extra-ordinary return from investing in bursa, you end up losing your hard earned money speculating in lemons.

XINGUAN...HAD A VERY STRONG BALANCE SHEET ON PAPER LOH...!!

"Raider says if u faced with blatant extreme fraud and misrepresentation of the management who ignore any convention corporate governance and accounting & reporting standard and do not follow basic principle of ethic and law, how can u use any fundamental measurement like PE leh ??"

IF THE XINGUAN MANAGEMENT...DECIDE TO MAKE UP THE FINANCIAL STATEMENT ON PAPER LOH..TO PASS ALL THE FINANCIAL TEST...EVEN MAGIC FORMULA...IT IS NOTHING WE CAN DO TO DETECT AND AVOID LOH...!!

THE KEY DEFENSE FOR RAIDER IS THE TEST ON CONSISTENT DIV AND CORPORATE GOVERNANCE LOH....!!

FINAL DEFENSE IS NEVER INVEST MORE THAN 10% ON ANY SINGLE COUNTER LOH..!! TO AVOID MAJOR BAD LUCK AND MISTAKE LOH...!!

2017-07-16 22:59

stockraider,

Isn't this statement in the article stated that one must avoid all red chip companies, despite of whatever they say in their financial statement?

"The caveat is you must first avoid all red chips and companies with suspicious financial reports."

2017-07-16 23:05

RAIDER SAY GIVEN THAT WE ARE LOOKING AT THE REAR MIRROR AFTER THE OCCURENCE OF EVENT...THUS EASILY WE CAN SAY AVOID ALL RED CHIPS LOH...!!

BUT WITHOUT HINDSIGHT HOW LEH ??

ONE GOOD CURRENT EXAMPLE OR TEST NOW....IS SHOULD WE INVEST IN HUGE UNDERVALUATION LOW PE STOCK LIKE HRC AND PETRON ??

IF U INVEST...U WORRY TOO GOOD TO BE TRUE SCENARIO...!!

IF U COMPLETELY AVOID...U MISS GREAT GOLDEN OPPORTUNITY LOH..!!

IT IS A DILEMA TO VALUE INVESTORS LOH..!!

THIS MAYBE A GOOD TEST LOH...!!

2017-07-16 23:12