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Monday, December 17, 2012

Watch PE when valuing a company

Markets jack up the price earnings ratio in expectation of growth and this, in turn, boosts the share price

 17 Dec 2012 09:39 TEH HOOI LING

 Groupon spurned Google and went for a public listing instead. For a while, it appeared that Groupon had made the right decision. - REUTERS

How does the market value a stock?

Take the example of Groupon, the online coupon service provider. This year, its stock price sank by some 80 per cent – from above US$20 (S$25) to below US$5.

Back in 2010, Google wanted to buy Groupon for US$8 billion.

But Groupon spurned Google and went for a public listing instead. For a while, it appeared that Groupon had made the right decision.

On the first day of its trading, its shares surged to US$26, giving it a market value of US$16.7 billion. Now Groupon is only valued at about US$2.8 billion.

So within one year, nearly US$14 billion disappeared from the value of Groupon, the company.

How did that happen?

Well, it’s got to do with market’s expectation of its future growth.

Bloomberg reported recently: “As competition intensifies and demand wanes, analysts see (Groupon’s) revenue growth slowing to 0.6 per cent in 2015, down from 45 per cent in 2012 and the 1,233 per cent average in the past two years.”

It’s rare to have a company that can sustain a growth of 30-40 per cent a year for a long time.

If it is a high growth market, you can bet that a lot of new entrants will be attracted to it – unless there are licensing rules or intellectual property restrictions to stop them from coming in.

Otherwise, new entrants would compete for market share, drive down prices, and crimp a company’s growth.

When growth slows, valuation falls.

Stock analysts and the stock market use various methods or metrics to value a company.

The most common metric is the price-earnings (PE) ratio.

Say there is a coffee shop called ABC. This year, ABC raked in sales of $500,000. After deducting all its costs, the owner – say a Mr Tan – made a net profit of $50,000.

Next year, Mr Tan has a big marketing campaign planned for his coffee shop. With the campaign, he reckons he can increase traffic to his shop, and raise his prices as well.

He forecasts sales will go up to $725,000 and net profit to $65,000. Mr Tan wants to sell his coffee shop. How much would you pay for it?

If you pay $250,000, then you are paying five times the historical earnings of the coffee shop, or a PE of five ($250,000 divided by $50,000). Based on this past year’s earnings and assuming it stays constant, you’ll take five years to get back your initial investment.

If you pay $500,000, you are paying a PE of 10 times. This means you will take 10 years to get back your capital.

But if you believe Mr Tan’s forecast, that the coffee shop’s earnings will grow by 30 per cent to $65,000 next year, then a price tag of $250,000 translates to a prospective or forecast PE of just 3.8 times.

Potentially, you can get back your investments in 3.8 years, or shorter if the earnings continue to grow the year after.

So in expectation of the growth, the market will jack up the PE ratio today.

One theory has it that a stock should trade at a multiple equivalent to its sustainable growth rate.

If the company can grow at 10 per cent a year, then it should trade at 10 times earnings. Twenty five per cent a year, and the valuation goes up to 25 times.

But as we have discussed, growth is not guaranteed.

A lower growth outlook poses a double whammy for prices of high PE stocks.

Say ABC is a listed company with one million shares. So its earnings per share (EPS) is $50,000 divided by one million shares. That works out to 5 cents a share.

The market is bullish about ABC and is expecting it to grow its EPS by 40 per cent next year to seven cents. To take into account its fast growth, investors value the stock at 25 times its forecast earnings. That would put its share price at $1.75.

But subsequently the global economy slowed down, or news emerged that a new formidable competitor has entered the market.

Now the outlook for the company is less certain. Analysts start to downgrade ABC’s forecast growth to, say, 10 per cent.

That would put its forecast EPS next year at 5.5 cents. Lower growth also means lower multiples of, say, 12 times. Hence, the share price would fall to 66 cents.

A 21 per cent downgrade in earnings forecast could lead to a whopping 62 per cent decline in share price!

What you want to be is on the other side of the equation. Buy a stock when it is trading at, say, five times its EPS of 5 cents, that is, at a price of 25 cents a share.

The following year, assuming the company makes 5.5 cents, the market starts to notice it.

Analysts become excited about the company and think it can grow its EPS by 15 per cent to 6.3 cents the year after.

And they think the company deserves a PE of 10 times because of its higher growth and consistent record.

So the price goes up to 63 cents. Voila! You’ve made 150 per cent return on your investment!

Next week, I will show the performance of consistently buying a basket of low PE stocks over a period of 22 years.

It’s pretty impressive.

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