Warnings about PE-based valuations 1 comments

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I have been using PE as my chief form of stock valuation and I still use it now. However, my experiences have taught me that using it too liberally without any careful consideration or understanding takes away the contrarian advantage. Low PEs might not imply a good bargain.

Firstly, PE valuations should be interpreted in the context of the industry in which the company in question operates. Growth industries typically command higher PEs, since their expected growth rate is higher. Besides earnings growth, there is also potential for upward PE re-rating by analysts/market for such growth industries. Sunset industries like retail would be typically priced at lower PEs. I have also mentioned the classic cyclical industries like steel, paper and oil where low single-digit PEs during boom times may be a signal that the cycle is peaking.

Secondly, PE valuations vary across countries. The US is the world's largest and most liquid stock market; its top counters typically trade at 30-40 times PE; anything below 20 is considered cheap. Singapore blue chips typically trade at 15-25 times trailing PE. The South Korean market, if I read correctly, trades at PE valuations of about 10 times, which is quite strange given the strength of their economy. Perhaps it is due to North Korea, and the typically high debt financing structure of Korean companies. Even within the same market, stock listings from different countries can command different PE ratings. Note how the China stocks on the SGX are priced now: many are trading at below 6 times trailing PE!

Thirdly, PE valuation techniques tend to fall flat if the company exhibits negative earnings growth ie. profit falls year-on-year. A stock can be trading at an attractive PE of 5 times but if its profit drops by 50% this PE becomes 10 times -- hardly attractive now. It is important, if one is going by the PE as the main valuation tool, to be comfortable with the company's earnings track record and medium-term prospects. If earnings fall instead of growing, not only does the price drop at constant PE (due to the drop in E), but at the same time the PE rating by the market also tends to drop due to perceived diminished growth prospects, hence compounding the value investor's agony.

Generally, in addition to the PE, it is also useful to use the P/NTA (Net Tangible Assets) as a guide to ensure one is not drifting too far from the breakup value of the business. We sometimes read about acquisitions made by some of these listed companies, and it is instructive to see such typical acquisition valuations: quite often they are made at 1 or 2 times the NTA/3-4 times PE, of the acquiree. So one should think twice before paying 5 times NTA or 20 times PE on the market for a stock.