Sunday, June 03, 2007

Price Earnings Ratio and Earnings Yield (Again!)

One way of using Price Earnings Ratio (PER) is to look at its inverse: Earnings Yield. This has been discussed in a previous post, but I would like to emphasize the importance of Earnings Yield, hence the PER strikes back. Do not under-estimate the power of PER… Ok ok, let’s move on.

Earnings yield is the inverse of Price Earnings, meaning when I say I will only buy stocks with PER of 18x and below, I am actually saying I will only buy stocks with earnings yield of 5.6% and above. Or stocks that will give me 5.6% return over the long run. (1/18 is 0.056 or 5.6%, this is what I meant by the inverse)

Consider the China market now. Its PER is over 40x. This means that the Chinese farmers and the Chinese students are willing to buy stocks that will actually only give them 2.5% return (1/40 is 0.025 or 2.5%). They might as well put their money in fixed deposit in Singapore! The other time when the PER of a market reached 40x was during the dot com bubble. Of course, with bubbles, you can never know when it will break, so 40x can go even higher, to 100x. And with China, it may be possible bcos there are maybe another 800mn farmers and students waiting to open brokerage accounts. This is the perfect Greater Fool Game, if you are those who like to play this game.

Earnings yield can also be incorporated with the risk-free rate to calculate the equity risk premium, i.e. the excess return to investors who are willing to risk their money to get better return, hence a risk premium. Remember higher risk, higher return. For STI, the earnings yield currently is roughly 5% while the risk free rate is roughly 3%, so investors are being compensated an additional 2%, the equity risk premium, for investing in risky equities or stocks. That’s actually quite low by historical standards. Equity risk premium should be around 3-5% on average.

For the case of our lovely China, the risk-free rate is now roughly 3% while the market earnings yield is 2.5%. This means that the equity risk premium is actually negative! 2.5% minus 3% gives -0.5%. You are being penalized to invest in risky equities. This is higher risk lower return! What an ingenious break-through!

However, I must stress that a lot of this stuff is academic talk and offers little help in the real world, China’s equity risk premium can go to -3% for all you know, meaning the stock market can still double from current levels.

But earnings yield is a very handy concept to use when you want to gauge the potential return that you will get from your investment (if you hold for the long term). Next time you want to buy a stock with PER 30x, ask yourself, am I ok with this stock giving me a mere 3.3% return over the long term? I would advise you to go open fixed deposit!

7 comments:

  1. Yes, no one would be able to tell how mad the market can gets as long as there're enough fools to drive the market from 40 to 100 in earnings multiple.

    But then there's no rule that says an investor must always keep his chips on the table. Capital allocation is all about knowing when to place his bets and when to withdraw from the table.

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    on more about malaysia stock trading online. Good to share. Thanks.

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  3. But there are some stocks where 40x historical PER can be reasonable or even undervalued. If the business is able to grow at a high annual compound rate for many years to come, then it fully justifies the high historical PER.

    Which is why I find your pt that 40X PER equates 2.5%p.a somewhat untenable, as these China stocks are definitely not going to remain static at their historical performance. It is the future growth that makes it possibly much more than 2.5%p.a.

    I agree with your basic pt that an average 40X PER for the whole market is a tad too excessive though... At the end of the day, we need to be clear what we are buying into instead of blindly following.

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  4. When looking at a stock with high growth, it is better to use its forward PER a few years down the road, if we can accurately forecast that, it will be the real PER for the firm, and it should not be 40x, more like 20x or less. Of course this is easier said than done.

    But let's say we just look at its next FY PER and it's 40x. In order to justify the 40x, the earnings will have to grow roughly 40-50%. If the co. succeeds, then it is only fairly valued. But if the co. doesnt succeed, then you are in for a rough ride.

    In short, buying 40x PER co. has no margin of safety, even if the co. can actually grow 40-50%. That's why it is always not safe to buy stocks at such high valuation.

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  5. Agreed.

    Just thought that the notion of growth (which is something that historical PER cannot show) was not brought out in the original blog posting, so I wanted to point it out for readers :-)

    Maybe next time you could do a post on growth, forward PER, and some of those astronomical optimistic projections of analyst to justify sky high valuations. :-)

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  6. I found another evidence that will support further bubbling. China mkt cap is now USD2.3 Trillion, roughly 44% of its GDP;and 44% is actually the lowest among top 30 stock markets worldwide. So u r right, there will be more fools coming in...

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  7. Sorry, how do we come about getting the risk free rate data from? Thanks

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