The P/E Ratio A Relative Metric When Utilized To Calculate Future Returns
Perhaps the most important thing to realize when using P/E ratios as an investment tool is that the P/E ratio by itself tells you very little about the return potential a stock might offer. As previously discussed, the P/E ratio represents a level of soundness based on the earnings yield it represents. Therefore, the P/E ratio’s true value is as a barometer or tool best utilized to measure soundness. Unfortunately, many investors fail to realize this, and therefore, miss the long-term benefits that an understanding of the relevance of the P/E ratio at various levels offers.
The P/E ratio, used properly, can assist the investor in the rational evaluation of the realistic probabilities of achieving a certain long-term rate of return and the amount of risk taken to get there. However, this can only be accomplished when the P/E ratio is evaluated in relation to a stock’s past, present and future capacity for growth. The primary metrics available to measure a company’s growth potential are earnings, cash flows and revenues. However, when utilizing the P/E ratio, it is solely based on earnings.
When a stock is purchased at a sound valuation, it represents prudence on the part of the buyer. However, from that point forward, future returns will be a function of how fast the underlying company can grow its business. Therefore, you can pay a sound valuation represented by the same P/E ratio of 15, for example, for two companies, one of which is growing faster than the other. However, even though your purchase might be prudent in both cases, the faster growing company will generate a higher long-term total return.
With the following examples I present a complete F.A.S.T. Graphs™ to include dividends on the slow-growing Southern Co (NYSE:SO) versus the faster-growing but lower-yielding Ball Corporation (NYSE:BLL). I have run calculations on historical returns on both companies based on investing as close as I could to a P/E ratio of 15 at the beginning and at the end. In both cases, the 15 P/E ratio valuation reference represents soundness. However, a faster-growing Ball Corporation produced significantly higher total returns.
Summary and Conclusions
With this part 1 of a two-part series I demonstrated the value and the validity of the P/E ratio as a valuation tool for companies growing earnings at 15% or less. I pointed out that a P/E ratio of 15 represents an earnings yield of 6.67% which I consider a minimum threshold for low to moderate growing businesses. When the P/E ratio of companies that fall within this growth rate is higher than 15, the investor should realize that it represents an earnings yield that does not compensate them for the risk they are taking.
But more importantly, as it relates to the promise in the title of this article, the P/E ratio is more relevant than the PEG ratio for companies falling into these earnings growth rate capabilities. However, in part 2, I will discuss the superiority of the PEG ratio as a valuation metric when examining growth stocks. As a clue, a PEG ratio of 1 is considered attractive and PEG ratios above 1 are considered less attractive.
However, when examining companies with earnings growth rates lower than 15%, the PEG ratio will always be above 1, and sometimes significantly. In the case of a low growth stock such as Southern Company presented in this article, even at a fair valuation P/E ratio of 15 its PEG ratio would be 7.5 (15÷2). Such a high PEG ratio would suggest that the company was significantly overvalued when its P/E ratio was 15 even though it is not.
With that said, I am a major advocate of the PEG ratio as an important valuation tool when evaluating fast-growing companies. For companies growing earnings at 15% or greater, I consider the PEG superior to the P/E ratio as a valuation measurement. In part 2, I will state my case as to why.
Disclosure: Long VZ, SO, GPC, SWK
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
Note: This article is written by Chuck Carnevale and was originally published at FASTgraphs.com.
