It seems ironic that one of the most universally known valuation metrics, the priceto-earnings ratio (PER), which is widely used for its “simplicity”, is still so misunderstood by many, not just the man in the street but also seasoned financial journalists, analysts and fund managers, even those on CNBC.
PER = Market price per share / Earnings per share (EPS)
The calculation of the PER is simple enough — it is the share price divided by earnings (historical or forecast) — and can be done quickly, which we think is the biggest part of its appeal. It is also easy to communicate — it basically tells how many times you are paying for each dollar of the company’s earnings or profit. And one could determine whether the stock is cheap (undervalued) or expensive (overvalued), either on its own by comparing to its historical PER or relative to other stocks and the broader market — at least that is what the financial journalists, market commentators and analysts will tell you. They would be wrong.
Obviously, stocks are either fairly priced, or they can be overvalued or undervalued, which is when you can profit from it. But the PER, in itself, tells you nothing about the stock’s underlying valuation or whether you should be buying or selling, despite what it purports to do. A PER of 9 times does not tell you if the stock is undervalued and neither does a PER of 229 times say it is overvalued. (Please also refer to our article titled “A PER of 9 or 229 times says nothing about relative valuations”, published in The Edge, Jan 8, 2018 by scanning QR Code 1) Similarly, a stock that is trading at 40 times earnings compared to 60 times last year is not necessarily cheaper today, while one that is now trading at 20 times versus 10 times two years ago does not mean that it is more expensive. And if anyone tells you otherwise, then they likely do not understand valuations or are not telling you the whole truth. Here is the reason why.
The one and only reason to buy a financial asset is for its future cash flows — from which the company will reward shareholders with dividends, share buybacks and/or reinvest for future growth. Hence, the valuation for a company is the sum of its future cash flows, discounted for risks and time value of money. In other words, the correct valuation methodology is, and always will be, the discounted cash flow (DCF). All other valuation metrics, including the PER, are just short forms (simplified versions) of DCF.
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DCF or PV= CFt+1 / (1+r)1+CFt+2 / (1+r)2+…+CFt+n / (1+r)n
This is the formula for the DCF (or the present value, PV) for a stock, which is also the price (P) you should be willing to pay. (Cash flow = CF and r = discount rate)
PV or P = CF / (r - g)
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The DCF formula can be further simplified by assuming r and g (growth) are constant. The PER calculation is derived from this and by further assuming that earnings (E) = CF (yes, this itself is a huge assumption given that accounting profit is, most assuredly, not the same as cash flows), then
P = E / (r - g) and therefore,
P/E = 1/ (r – g)
Clearly though, it is not possible that r and g are constants in the real world. The discount rate, which reflects the risks, is constantly changing, due to changes in monetary policy (inflation and interest rates), macroeconomic conditions and business (industry and company-specific) environment. The company’s growth rate is also continuously changing with time, as demand and margins shift due to new innovations, obsolescence, market saturation, new competition, change in consumer preferences, regulations and so on. Based on the formula, if g can exceed r in perpetuity, then the stock value would theoretically be infinite. Some may argue that this is the case for Nvidia, given that its chips are (currently) the building blocks for the artificial intelligence boom. But realistically, this is not probable as there is always a limit on growth.
Every product (and service) goes through a life cycle, from infancy (low growth) to expansion (rapid growth) to maturity (low growth) — what economists call the S-curve. Some S-curves have greater longevity (product has long lifespan) while others are short, and some S-curves are steeper (faster and stronger growth) than others. But inevitably, no matter how successful the product is, growth must slow and decay. Successful companies are those able to continuously reinvent, reinvest and create new S-curves, to start new growth cycles. (Please read our article titled “Business cycles — successful reinventions and those that fail”, published in The Edge, April 8, 2024, for a more detailed explanation by scanning QR Code 2.)
The point is, the valuation for a company and therefore, its implied PER, is not static. It is constantly shifting as expectations for cash flows, discount rate and growth change. Hence, trying to compare the PER of a stock today against what it was in the past to determine if it is undervalued or overvalued is just as meaningless as trying to determine whether a stock with a PER of 9 times presents better or worse value than a stock with PER of 229 times. We will demonstrate this mathematically using three different scenarios.
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Scenario 1: A typical S-curve
Scenario 1 is the simplest of examples — that of a single-product company, whose demand and earnings go through the typical S-curve life cycle, from infancy to maturity. At the beginning (Year 1), the stock’s valuation — and by extension, its implied PER — based on discounted future cash flows is very high. This is because the company is at the “infancy” phase and just starting to grow and grow rapidly going into the “growth” phase. Over time, growth will slow and taper off when it reaches the “maturity” phase. By Year 16, the PER has dropped to just 10 times because there is very little growth left and the risk is high that earnings may even start falling. Someone looking purely at the PERs may tell you that the stock is very cheap since its PER is only 10 times compared with 18 times five years ago (Year 10) or the last 10-year average of 24 times. And they would be very wrong!
Scenario 2: Earnings fall after hitting maturity stage
In Scenario 2, imagine that earnings start declining (instead of sustaining in Scenario 1) after hitting the maturity stage (see Scenario 2). This would happen if, for instance, the product is being replaced by a newer and better alternative or it has lost market share to a competitor that is able to produce and sell it at a much cheaper price. As the valuation (discounted future cash flows) shrinks, its implied PER falls to the single digits. Does this mean the stock is cheap — PER is only 7 times by Year 20 compared to 10 times in Year 13 and 20 times in Year 9 — and therefore you should buy it? Obviously not.
Scenario 3: Finding a second S-curve, a new engine of growth
Now, let’s assume that the company successfully reinvents itself and adds a new engine of growth, say, by diversifying upstream or downstream or acquiring a related or entirely new business. We see its implied PER falling to 14 times by Year 10, at the end of its first S-curve but then starts picking up again as growth from the second S-curve kicks in (see Scenario 3). Eventually though, the second product (or business) must also reach its maturity phase where growth slows and flattens out, which is also when the implied PER drops again, to 10 times by Year 23.
A matrix table guide to PER valuations
The matrix table can provide the average investor a useful framework of the relationships between PER valuations and a company’s growth (g) and discount (r) rates. It is basically a “look up” table, which can be a useful tool in determining if a stock is undervalued or overvalued at any point in time.
For example, what does it mean if a stock is currently trading at 33 times PER? How do you determine if this 33 times valuation is fair, undervalued or overvalued? We have highlighted all the relevant boxes (33 times PER), calculated from different combinations of r and g. In other words, the market is pricing the stock assuming one of these eight combinations:
- g = 0 and r = 3%
- g = 1% and r = 4%
- g = 2% and r = 5%
- g = 3% and r = 6%
- g = 4% and r = 7%
- g = 5% and r = 8%
- g = 6% and r = 9%
- g = 7% and r = 10%
Next, you must decide what the stock’s risks are and therefore, the appropriate discount rate. Say, it is 6%. At this discount rate, the stock’s current 33 times PER valuation assumes that it can grow at 3% in perpetuity. Bear in mind, this is the perpetual growth rate, not just the growth for this year or the next two years.
Hence, the question then is do you believe the company can grow at 3% forever, or will growth be faster or slower? If you think 3% growth is reasonable, then the stock is fairly valued. If you think it can grow faster than 3% in perpetuity, then the stock is currently undervalued. Say, you think it can in fact grow at 4%, then the stock should be valued at 50 times PER. If, however, you believe the company can only grow at a constant rate of 2%, then the stock is overvalued. Its PER should drop to 25 times.
Remember, this table presents the PER valuations at one point in time. If you perform this same exercise next year, your assumptions on r and g may change, and therefore a reasonable PER today may not necessarily be true next year.
Conclusion
Now imagine in the real world, there will be endless new products, new competitors, ever-changing consumer tastes and lifestyle, and so on and so forth. There will be many successful as well as unsuccessful S-curves, each with unpredictable outcomes. The implied PER at any point in time will tell you next to nothing as to whether the stock is undervalued or overvalued.
Indeed, there will never be a precise “valuation” because the potential future cash flows are derived from assumptions made on growth and risks based on beliefs and the “story”. Different investors will have different valuations, based on their own set of beliefs and assumptions. Valuations are also driven by market factors such as liquidity — stocks with higher liquidity tend to have higher PERs, since the risk of not being able to cash out would be lower. The sum of all these differences is what creates the “market clearing” prices and that makes the stock market, which is a market (driven by demand and supply) for stocks.
It’s okay if you are feeling a little confused. Value investing is complicated because real life is complex, and the future is filled with uncertainties. There are many, many factors that will affect valuations for stocks, sometimes in totally unpredictable ways. Financial commentators, journalists and analysts use the PER in their narratives because it is “simple”. Just be aware that PER is meaningless when used in isolation to determine if a stock is undervalued or overvalued. Companies can have very high PERs (for instance, in turnaround situations and at the expansion stage of the S-curve), very low PERs (say, for businesses in the mature phase where growth is low or even negative) or the PER cannot be derived at all when the companies are making losses (which is typical for start-ups).
The PER is a snapshot at a moment in time — a “stock” concept. Stock valuation, on the other hand, is the flow of cash over the life cycle of a company — a “flow” concept. The two are very different.
Additionally, most analysts are overly focused on profit and loss (for example, the PER and profitability) while neglecting the balance sheet, which is equally important. For instance, the amount of debt and leverage on a company’s balance sheet becomes critical when there is a sudden liquidity/credit crunch, when a “black swan” event leads to a financial crisis and/or global economic slowdown, when unexpected supply and payment bottlenecks happen and so on. As we said, investing is very complicated.
The PER is more useful when applied to the broader market and bellwether indices. For example, to say that the S&P 500 index is relatively expensive today given that it is trading at the higher end of its PER range of the past 20 years. The reason being the index consists of a basket of stocks. While the PER for individual stocks is always changing (and can fluctuate widely), the PER for a basket of many different types of stocks should be relatively more stable due to the averaging factor.
To understand this better, one needs to study portfolio theory. Individual stocks have systematic (those associated with the overall market movements) and unsystematic (that are peculiar to the specific company) risks. Therefore, if one puts together a portfolio say, of 20 companies, then the unsystematic or peculiar risks offset each other. This is the theory behind the reason for buying exchange-traded funds or ETFs.
The Malaysian Portfolio fell 1.8% for the week ended July 24, led by losses from Insas Bhd - Warrants C (-7.4%), Insas (-4.2%) and IOI Properties Group (-3.7%). On the other hand, KSL Holdings (+1.0%) and Malayan Banking (+0.4%) traded higher for the week. Last week’s losses pared total portfolio returns to 218.3% since inception. This portfolio continues to outperform the benchmark FBM KLCI, which is down 11.4%, by a long, long way.
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