Few investing approaches have garnered as much of a following as value investing; the investing standard made prominent by Ben Graham and David Dodd in their seminal 1934 publication Security Analysis. Few of us like overpaying for anything – be it a pair of jeans or having our homes painted. Value investing involves analysing various valuation metrics designed to guide us in not overpaying when investing in shares. Studies have shown that buying overpriced shares is a significant driver to having an underperforming portfolio.
The value investing approach consists of a number of processes the first of which is to identify stocks with low price to earnings (P/E) ratios. Various academic studies have confirmed conclusively that stocks with low P/E multiples have much higher returns and are less volatile than those with higher multiples.
In Jeremy Siegel’s authoritative classic Stocks for the Long Run, the Wharton Business School professor analysed the 500 companies comprising the S&P500 index. He found that, since 1957, investing in the companies with the lowest P/E ratios at the beginning of the year would have yielded over the next 12 months significantly greater performance than having invested in the stocks with the highest P/E ratios. He found that a portfolio invested in the highest P/E ratios stocks had returned 8.90 per cent annually while the portfolio with the lowest P/E ratios stocks had annual average returns of 14.30 per cent.
The P/E ratio often referred to as the earnings multiple is perhaps the most recognised and convenient tool used in gauging just how expensive a stock is. The P denotes the current price of the stock. The E represents the stock’s trailing or projected earnings per share (EPS) based on a 12 month period. So, if a company currently trades at €3 per share and earned 25 cents a share in annual net earnings the company would have a P/E ratio of 12 (P= 3.00/E = .25). Very often the EPS will reflect the trailing 12 month period.
Sometimes 12 month forward earnings forecasts are used. Both approaches have drawbacks. The problem associated with past earnings, is they are by definition backward looking, and may not reflect a company’s earning potential over the next year, particularly if economic conditions change. Although forward earnings can be more reflective of reality, forecasting future earnings can be complex and is an inaccurate process.
Another way of interpreting the P/E ratio is – it measures how many years it would take to recoup the cost of buying each share. In the above example assuming the company makes a constant 25 cents per share, it will take 12 years of earnings to recoup the cost of purchasing the shares (12yrs x 0.25c = € 3). A P/E of 12 also denotes that one is paying €12 for every €1 the company earns in net profits.
It’s important buying value stocks with P/E ratios which are low in relation to the company’s five year average P/E, to its competitors’ P/E and to the market in general. As an example, Microsoft, the world’s largest software company, currently has a forward P/E ratio of 11 – low when compared to its five-year average of 13, low when compared to the software industry’s 15 P/E, and low again when compared to the S&P500’s current 18 P/E Ratio.
Very often the benchmark used for gauging the costliness of your typical stock, is to compare it to the S&P500’s historical 15 P/E ratio. Investors should proceed cautiously when P/E multiples are considerably higher than historical norms. Since the early 1900s, the S&P 500 index had P/E ratios ranging from a low of 5 in 1920 to a high of 44 in 2000. High P/E ratios signify the market may be too expensive, and a correction may ensue.
Stocks should never be bought blindly, based solely on a low P/E ratio. Other factors need to be assessed; most notably their prospects for future earnings growth.
Keep in mind the value investing process not only constitutes analysing a company’s P/E multiple, but also its price to book ratio, and intrinsic value. The attractiveness of the P/E ratio is its simplicity, and if used wisely, and in conjunction with other indicators, buying into a low price to earnings ratio can dramatically improve the prospects of your investing success.
Joseph Portelli is the managing director and chief investment officer at FMG Funds (Malta). He also is a lecturer at the University of Malta and the Institute of Investment Analysis.