Cotter On Investing. John Cotter

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СКАЧАТЬ be the one year forward PE.

      Although the trailing PE is based on verified figures, you don’t drive a car by looking in your rear view mirror, therefore I prefer this year’s forecasts to last year’s facts. The same comment applies to the CAPE but even more so. There is no doubt the CAPE will eradicate the chance of one set of figures giving a misleading reading, and although CAPE may be ideal for long-term financial studies, I cannot accept that earnings figures that could stretch back over a decade ago should play a part in tomorrow’s investment decision. The market itself is a forward looking animal. It’s a barometer, not a thermometer, and will always discount ahead. It therefore makes sense to use a measure that does the same.

      Interpretation of the PE

      As mentioned above, the PE is a measure of the value placed on a company by the market. If investors like a company they will buy the shares, which will drive the share price up, which will result in a higher PE. This is a simple function of the calculation of the PE. Remember, the formula is:

      PE ratio = share price/earnings per share

      If the earnings per share stay the same but the share price increases, this results in a higher calculated PE.

      Conversely, if investors dislike a company they will sell the shares, which will drive the share price down, which will result in a lower PE.

      Companies with high PEs are often referred to as being highly rated by the market, while companies with low PEs are often referred to as being lowly rated by the market.

       But the big question is: what level is considered high (or low) for a PE? For example, is a PE of 20x considered high?

      There is no short answer to that question. Different people interpret the PE differently.

      For example, growth investors may regard a PE of 30x as not unreasonable if a company is expected to grow strongly. Whereas a value investor (like Warren Buffett) prefer companies with low PEs. It is not surprising that Buffett never invests in technology companies (that often have high PEs).

      Personally, I align myself with Buffett and prefers companies with low PEs. A low PE shows that the stock is cheap relative to its earnings. We know that price and earnings are inextricably linked, which makes the low PE stock a safer proposition with a lower downside risk.

      Using the PE to compare stocks

      The absolute level of a share price tells us little about a company. Knowing that AstraZeneca has a share price of £28.74 and GlaxoSmithKline has a share price of £11.70 tells us nothing about the absolute or relative merits of these two companies. But comparing their PEs can be useful. In this case, AstraZeneca has a forward PE of 7.1x, while GlaxoSmithKline has a forward PE of 9x. This tells us that the market places a higher rating on GlaxoSmithKline than AstraZeneca. So, while its share price may be nominally cheaper, GlaxoSmithKline shares are regarded as more expensive than those of AstraZeneca.

      The job of the investor is to consider whether the market has got it right. If an investor believes that the prospects for AstraZeneca are as good (or even better) than GlaxoSmithKline, then he would regard AstraZeneca as currently being good value relative to GlaxoSmithKline.

      Examples

      Let me demonstrate how I use the PE to assess stocks.

      The following table lists some stocks and their forecast PEs. For comparison, the market as a whole had a PE of 13.5.

Company	Forecast PE
ASOS [ASC]	70
Dominos Pizza [DOM]	33
Aggreko [AGK]	19
GlaxoSmithKline [GSK]	9
Xstrata [XTA]	9

      The forecast PE shows that online clothes retailer ASOS is very expensive now after a period when it defied the recession with a share price rise of about 1500% over five years. After share price growth at this rate I suppose you would expect it to be expensive; and the PE shows it to be over five times more expensive than the average share. It may still be a quality company but without doubt you are now paying a high price for that quality.

      Maybe more people like pizzas than I think, but the current PE rating on Dominos looks very expensive to me.

      Aggreko is a global supplier of mobile power and has supplied events such as the football World Cup and the Olympics. It has been one of the stars of the FTSE in recent times with its PE increasing from nine three years ago to 20 at the time of writing. In other words, it has moved from a cheap share to a relatively expensive one. It is a company that I still like, but its present rating is a little high, which makes me think the stock price will, at least, pause for breath before resuming its growth.

      The PE on Glaxo appears too low. It has moved from a growth stock to a value one with a PE of less than ten and a dividend of more than 5%. Have the heydays of the big pharmaceutical come to an end? Obviously, judging by its PE a lot of investors think so. It’s true that fewer new drugs will come to the market in the future; and at the same time more of the old ones will lose their patent protection and face competition from cheaper generic versions. In addition, potential litigation costs are rising. Obviously, different views abound – after all, that’s what makes a market in the first place. But I believe that this share is now too cheap. The present PE ratio would indicate to me that this company would justify inclusion in a portfolio as a lower-risk, high-dividend player. Although the growth potential is less than many shares, so is the downside. Successful stock investment is about investing in shares where the risk-reward ratio is skewed in your favour.

      Finally, Xstrata [XTA] looks cheap with a PE of nine. Will growth in China and emerging markets continue to support the price of commodities? Obviously, this rating suggests that many think it will falter. However, this PE looks too cheap. In fact, many of the miners do. BHP Billiton [BLT] has a similar rating of ten which may suggest much of the mining sector is undervalued at the present time.

      Obviously, the above views are purely personal and they have a limited shelf life. However, hopefully this quick overview demonstrates that when it comes to assessing individual shares PE ratios have a part to play.

      In isolation they do not provide the whole picture, but they do provide a few pieces of the jigsaw. They provide a background against which the share and its current price can be assessed. They tell you whether the stock is cheap or expensive and once this is established you are able to make other value judgements. Used in this way, they can simply help you make more informed investment decisions.

      Using the PE to compare companies in different sectors

      Some people feel when making stock comparisons the PE is only useful when you compare stocks within the same sector. Although I understand the logic here, I don’t agree with it. Some sectors offer the promise of growth more than others (e.g. bio-techs) and this will be reflected overall in higher PEs. However, this simply means that the sector is more expensive. Investing within it inevitably СКАЧАТЬ