The pitfalls of P/E ratio and their solutions

“If something is easy to compute and understand, it is extremely unlikely that the market will misinterpret it. Therefore, such information will not, by itself, provide evidence of mispricing.”

We saw in my last article that a portfolio of 104 low PE stocks 5 years ago had a cumulative average return of 181% and 103% median return compared to the 51% return of the broad KLCI. 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.

http://klse.i3investor.com/blogs/kcchongnz/62822.jsp

There are some major problems with both the numerator and the denominator of the P/E ratio.

Let us consider two companies, A and B in exactly the same industry having the same number of shares of 100m with the same share price of RM1, hence the same market capitalization of RM100m as shown in Table 1 below.

Table 1

The difference is that A has a total debt of 50 million and cash of 10m, whereas B has a total debt of 10m but cash of 20m. Assuming everything else equals, which company will you prefer to buy? Obviously company B is more attractive as it has more cash and at the same time less debts.

Table 2 below shows the income statements of the two companies:

Table 2

Company A, with higher earnings before interest and tax but has to pay interest because it carries higher debt. After interest and taxes, both companies make the same net income of 10m. Hence both A and B is selling at a price-earnings ratio of 10 (100m/10m).

Now taking the two scenarios above together, which company do you prefer to buy?

There are a whole lot of other problems associated with the earnings E in the P/E ratio. For this, I would like you to refer to my article here:

http://klse.i3investor.com/blogs/kcchongnz/45373.jsp

In the above article, these are some of the funny things happening to the E of the companies involved which makes the P/E ratio useless as a metric to determine the cheapness of a stock.

1. Hibiscus sold some shares of a joint venture to a third party and recognize a gain, or earnings E of RM13.5m during the last quarter of 2013 when the revenue was only RM6.7m.
2. Asia Media played with its capital expenses to boasted revenue and fake profit E in 2012.
3. KNM showing some earnings albeit small but with huge build-up in receivables in billion, and hence negative cash flow from operations. Was that little earnings E even real?
4. CSL at 75 sen then was trading at fantastic low PE ratio. It is trading at 10 sen now. What happen to this earnings?
5. Guan Chong at RM1.80 then was trading at a very low P/E. The same story of cash flow from operation has been negative for years. We are not even talking about free cash flow. Huge amount of earnings E was tied up in inventories and receivables. Are all those earnings real? They certainly didn’t appear to me so. GCB closed at RM1.05 today.
6. Ivory Property, a darling developer in Penang, showed good earnings and a single digit PE ratio at 77 sen then. A closer scrutiny of its financial statements showed one time revenue (from gain in revaluation of land?) was booked as earnings E. Same thing no positive cash flow from operations. What kind of E was that?
7. London Biscuits, at RM2.50 in 2005 showed P/E ratio of single digit of about 5. Same story poor cash flow and every year borrows more and more. Do you expect people to believe that E is real? It closed at 74 sen today.

So can you trust the E in the P/E ratio?

One way to minimize this problem is to look at the earnings before interest and tax (Ebit), a number before all the extra-ordinary items such as gain in revaluation of assets, gain in foreign exchange, gain from sales of land and other assets etc which are one time off and non-recurring.

As Ebit is the income for both the equity and debt holders, enterprise value is used instead of the market capitalization. This ratio of EV/Ebit replaces the too simplistic P/E ratio to determine if a company is worth buying.

EV/Ebit, like the PE ratio, is a measure of how cheap, or expensive a stock is selling. It doesn’t take into consideration if the performance of the company is good or not. Of course a better performing company should rightfully be selling at a higher P/E, or EV/Ebit ratio. To complement that, we also use return on capital (ROC) first to determine if the company is a good company, then if it is selling cheap. That is the essence of the Joel Greenblatt Magic Formula Investing.

Our experience in using EV/Ebit and ROIC in Bursa

One of the participants of my first online investment course, Noby, put up a portfolio of 18 stocks having the highest scores in the magic formula on 6^th June 2014 as shown in the appendix. This period until now has been a turbulent and volatile period in the stock market with the KLCI dropped by 30 points from 1863 to 1832, or 1.7%. Many second and lower liners dropped by much bigger magnitude in the same period.

Five months has passed and the portfolio of stocks are split between equal number of gainers and losers. It returned an average gain of 4.6%, or a positive alpha of 6.3%, not bad at all considering those stocks are lower liners. The biggest gainer is SKP Resources with a gain of 86% followed by Latitude Tree of 30%. The biggest loser is TurboMech with a negative return of 19%, followed by Sapura Industry at 12.1%. The bigger gainers gained much more than the biggest losers have lost. That is the essence of a successful investment.

We have shown that the magic formula works well in long term.

http://klse.i3investor.com/blogs/kcchongnz/55070.jsp

It also appears to be superior investing strategy in the short-term as shown in the return of this portfolio as compared to the broad market. It is however too short a period and too small a sample of stocks to prove the success of the strategy. Nevertheless, the strategy is actually quite intuitive; buying good companies on the cheap provides the downside protection, with the upside taking care of itself.

The success of the strategy will be enhanced if additional works such as valuations are carried out to estimate the intrinsic value and hence the margin of safety to augment each investment thesis.

For those who are interested to learn about the magic formula and other investment strategies, financial statement analysis and interpretation and valuations, please contact me at

Ckc14training2@gmail.com

K C Chong (6^th November 2014)

Appendix