The Many Faces of PE - Quality

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

Growth
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 lastminute.com, a fly-by-night dotcom firm that does not exist today. You would have lost 80% on Amazon and 100% on lastminute.com.

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

The Many Faces of PE - Growth

This is a continuation of the previous post on the many ways to look at the PE ratio.

3. Growth Angle

As the investment world, led by brokers shifted to look at just 1 year PE ie PE using next year's earnings. A lot of imagination bloomed on how we can interpret this ratio. The most popular one being how PE can be used to tell the growth story. The rationale is simple enough: different companies and industries have different growth outlook. By looking at next yr's PE, we cannot just say that: ok, more than 15x is expensive, I am not going to buy anything more than 15x.

What if the industry is growing at 30% per year? Then 15x is cheap! By right, it should trade at 30x PE (see the rule of thumb below). Hence with this argument, basically the brokers can convince anyone to buy at any PE. The most recent case being Facebook, our most visited website nowadays. Facebook is being valued at USD 65bn, but its revenue is USD 1bn and profits probably half of that. This means that Facebook's PE is roughly 120x, yet investors are asking for more, they can't wait to buy it bcos on its first day of trading, it is bound to go up another 50%, ie its PE will hit close to 200x!

Well's that's the Greater Fool Game for you in Font Size 64.

But, back to reality, since the whole world looks at just next yr's PE, and it is the most accessible ratio, when we look at that number, we can also incorporate this growth angle mentality.

Basically the way I would look at it would be as follows (all based on just next yr's PE:

10x: either very cheap or the industry has no growth. Some telcos, nuclear stocks, dying industries trade at this PE

15x: Fairly valued, or cheap if growth is good (ie more than 20%).

20x: Expensive, very highly likely to lose money if we buy anything at 20x. The growth has to be 25% or more to justify this PE ratio.

25x: Nothing should trade above this (by right), no matter how good the prospects are. Think thrice if you want to buy a stock trading above 25x and then don't buy it. For more on this point, see this post: Valuation Expansion.

It is also industry rule of thumb to pay x multiple of x% of growth, ie if a stock is growing 15% we can pay 15x for it. There is no mathematical proof or strong financial concept behind this interpretation. It is, in every sense, just a rule of thumb. Some investors use this rule quite often. Even the value guys.

Of course this rule of thumb falls apart when the PE is too high or low. For eg, companies with no growth trades at 10x (usually), while Facebook which can probably grow 30-40% trades at 100x.

Hence I would usually demand more growth given the same PE. ie for PE 15x I hope to get 20% growth.

Next post: Quality!