Session 15: PE Ratios

Understanding the Price Earnings Ratio

In this session, the speaker discusses the widely used multiple in the world, which is the Price Earnings (P/E) ratio. The speaker explains that while most investors know what P/E ratios are, there are varying definitions of what they actually mean.

Definition of P/E Ratios

• The P/E ratio is internally consistent with equity value as both its numerator and denominator.

• There are different ways to compute a P/E ratio such as current PE, trailing PE, forward PE or even 2022 earnings.

• Different companies can have different numbers for their P/E ratios depending on how it's calculated. It's important to ensure that everyone involved in a discussion about P/E ratios has the same definition.

Analyzing P/E Ratios

• At the start of every year, every company for which a market price can be found is selected and a histogram of their P/E ratios is drawn.

• The distribution of P/E ratios is asymmetric with a peak to the left and tail to the right.

• While average current P for US stocks is over 80, median value for P/E ratio is around 16.5 which makes more sense to focus on than averages.

• Only about 3,000 plus firms out of seven thousand plus firms have available data for their P/E ratios.

Implications

• As multiples like P/E ratios involve making assumptions about growth, cash flows and risk implicit rather than explicit assumptions can sometimes lead to trouble.

Characteristics of P/E Ratio

In this section, the speaker discusses the characteristics of P/E ratio and how it can introduce bias in valuation models.

Subsample Bias

• P/E ratios tend to be biased towards younger, riskier companies.

• This introduces a danger when taking statistics from a subsample that is not an unbiased sample.

• Companies that are not tracked by analysts are lost for the sample, introducing subtle biases based on multiples used.

Asymmetric Nature of Multiples

• Multiples are asymmetric and throw off median and mean values.

• Comparing distributions across subgroups shows commonalities in peak-to-left tail-to-right distribution shapes.

• Median values vary across subgroups but not in predictable or easy-to-explain ways.

Global Market Share Commonalities

• Companies share more in common globally than they have differences.

• Emerging markets had higher median P/E ratios than European markets despite being considered riskier.

Analysis of P/E Ratio

In this section, the speaker explains how to analyze a multiple using the P/E ratio as an example.

Equity Valuation Model

• The simplest equity valuation model is the stable growth dividend discount model (Gordon growth model).

• Dividing both sides of the equation by earnings per share gives an equation for determining the P/E ratio for stable growth dividend-paying companies.

• Three variables drive the P/E ratio for these companies: payout ratio, cost of equity, and expected growth rate.

Propositions About Variables Driving P/E Ratio

1. Higher growth rates lead to higher P/E ratios.

2. Higher-risk companies should have lower P/E ratios.

3. Higher payout ratios lead to higher P/E ratios if holding other factors constant; however, holding other factors constant is difficult to do.

Balance of Growth, Risk, and Payout Ratio

In this section, the speaker discusses the challenge of balancing growth, risk, and payout ratio when analyzing a company's P/E ratio.

• The net effect of balancing growth, risk, and payout ratio is what determines whether the P/E ratio will be positive or negative.

• Companies with higher growth tend to have higher risk and lower payout ratios.

• The big challenge in investing is looking at that balance.

Characteristics of a Perfect Company

In this section, the speaker discusses the characteristics of a perfect company that he would like to add to his portfolio.

Key Points:

• The speaker would like a company with low P/E ratio, high growth rate, and low risk.

• To screen for attractive stocks, look for companies with low price-to-earnings (P/E), low price-to-book (P/B), or any other multiple that should not trade at a low P/E.

• The speaker applies this framework to the beverage sector and identifies three companies with P/E ratios below 10:1 - Andre Wine, Todhunter, and Hanson Natural. However, upon closer inspection, only Hanson Natural meets all the criteria of being cheap with high growth and low risk.

• To control for differences in growth and risk across different markets, the speaker uses multiple regression analysis to predict P/E ratios based on expected growth rates and whether an ADR is from an emerging market or developed market.

Using Multiple Regression Analysis

In this section, the speaker explains how he uses multiple regression analysis to predict P/E ratios based on expected growth rates and whether an ADR is from an emerging market or developed market.

Key Points:

• The dependent variable in the regression is P/E ratio while independent variables are expected growth rates and a dummy variable indicating whether an ADR is from an emerging market or developed market.

• After running the regression analysis on telecom ADRs in 1999 using these variables as predictors of P/E ratios, the R-squared value was about 63%, which indicates that these variables explain about 63% of the variation in P/E ratios.

• The coefficients from the regression analysis can be used to predict P/E ratios for a particular company. When the speaker plugged in the numbers for Talib Rise, he found that it was not as cheap as it appeared due to its lower growth rate and higher risk compared to other companies.