Wednesday, June 15, 2011

The Many Faces of PE - Quality

This is the 3rd installment of posts titled "Many Faces of PE". The previous two posts are:

Shiller PE

It is important to bear in mind that PE can bear so many different faces bcos we look at just next yr's PE. This is a practice that the whole financial industry agreed on some time back even though it totally made no sense for investors. But it does help generate lots of trades and commissions though.

So when we just look at next yr's PE, peer comparsion and quality also comes into play.

4. Peer Comparison and Quality

Usually one would determine whether the stock is cheap vs its peers in the same industry. So when looking the PE of Singtel, we also look at Starhub and M1. The industry average PE would determine where some of these individual stocks should trade at.

Of course, in reality, this made little sense. If something is cheap, you don't have to compare it to confirm its cheapness. Vice versa, if something is expensive, you cannot try to justify buying its cheaper peer.

Say Singtel, it's PE is 11x, but do you say that Vodafone is 10x so Singtel is expensive and hence cannot buy?

On the 2nd point, RenRen, the facebook of China, if it IPO at 50x, do you say then it's cheap bcos Facebook is 100x?

I guess the point I am trying to make is that the absolute PE level is very important as well when we look at peers. If it's cheap, it's cheap. It is not very important talking about how cheap vs peers. At the big picture level, if the whole industry is cheap it probably means there is a lot of upside when the outlook changes ie buying anything in the industry will yield significant upside. As an example, in the midst of Lehman, UOB was trading at 0.7x Price to Book and DBS was 0.6x Price to Book. Did buying one over the other matter very much? UOB is up 2.3x since its Lehman low from $8 and DBS is up 2.4x from $6.

Vice versa for expensive names, if the whole sector is overpriced then owning any stocks in the sector meant huge downside risk if things go wrong. Just like during the dotcom boom, it doesn't matter if you got Amazon, one of the best dotcom firm and still going strong today, or, a fly-by-night dotcom firm that does not exist today. You would have lost 80% on Amazon and 100% on

Having said that though,PE usually also tells the quality story. If Firm A has a better management, with more robust processes, better products vs Firm B, the market knows and gives Firm A a higher PE. Just as an example, the better quality Firm A might trade at 14x vs a poorer quality Firm B at 13x.

Next: PE vs DCF
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