Saturday, June 23, 2007

Is buying high earnings-to-price (or low PE) stocks a good strategy?

Reader's Question: Is buying stocks with high earnings-per-share (EPS) as a percentage of stock price a good investment strategy? I am considering investing in a Bombay-listed Indian bank (current share price of 85 rupies) whose EPS has been about 15% of share price for the past three years. If this trend continues, will I be able to receive my initial investment back through EPS over the next six to seven years? Will all the EPS be deposited into my bank account?

Low PE: An Entree into Low PEG

We can restate your main question in more familiar stock market jargon by inverting your earnings-to-price percentage to get a price-to-earnings ratio: Does buying stocks with low price-to-earnings ratios (P/E) produce higher returns? A wealth of literature exists on this topic of low-PE stocks within the framework of value investing. Rather than rehash the basics, I cite an article available online--This Stock Is So Cheap! The Low Price-Earnings Story--for your edification and perusal. The author of the article draws this conclusion:

The conventional wisdom is that low PE stocks are cheap and represent good value. That is backed up by empirical evidence that shows low PE stocks earning healthy premiums over high PE stocks. If you relate price-earnings ratios back to fundamentals, however, low PE ratios can also be indicative of high risk and low future growth rates. . . . [A] strategy of investing in stocks just based upon their low price-earnings ratios can be dangerous. A more nuanced strategy of investing in low PE ratio stocks with reasonable growth and below-average risk offers more promise, but only if you are a long-term investor.

To the above, I would add that I tend to favor "low PEG" as a more useful indicator of potential upside than low PE. Since PEG is the "super-ratio" of price-to-earnings ratio divided by earnings growth rate ("PEG" = PE/G, where "PE" = P/E), PEG embodies a growth component that PE lacks. In other words, by considering low PEG stocks, investors can concurrently select both good current value (relatively low PE) and good expected growth (relatively high G). For a discussion of stock returns, EPS growth, PE and the importance of low PEG, please have a look at an earlier blog entry.

Investment Cash Flow: Fixed-Income vs. Stocks

If you could find a fixed-income investment that pays 15% current interest (some junior mortgages on real estate and certain junk bonds pay this type of return, though both involve considerable payment default risk), your annual scheduled investment cash flows would be what you have in mind: 15 dollars (or rupies if in India) for every 100 dollars (or rupies) of principal invested. Further, given a seven-year maturity, you would (assuming the borrower does not default) receive more than your initial investment back in interest payments (7 years x 15% = 105%), which, when combined with your principal, would actually amount to total cash flows of 205% (105% interest + 100% principal) over the full holding period.

Unlike fixed-income investments, stocks do not have any pre-scheduled set of cash flows. Although you might be able to buy a stock at an earnings-to-price percentage of 15% (PE of 6.7), there is no direct linkage between your investment cash flows and the company's earnings. Instead of making pre-scheduled payouts to equity investors, companies pay periodic (usually quarterly or semiannual) dividends which are typically some fraction of earnings. Based on earnings results, availability of cash flow and company policy, management can raise or lower dividends from one period to another.

With the exception of very long, multi-decade investment horizons, the primary determinant of your returns from stock investing will be, not dividends, but the terminal market value of the stock when you sell it (or simply wish to calculate your mark-to-market "paper profits" without actually selling). The uncertainty of the future price of a stock is what makes stock investing risky business but also has the potential of delivering great financial rewards to those who succeed over the long haul.

In your example of buying an Indian bank stock (possibly Andrha Bank?) at 85 rupies, your investment cash flows would consist of relatively small dividends, amounting to about two or three rupies per share per year. Whenever you decide to sell your shares, you will receive whatever the market price is at the time of sale, which, of course, can be either higher or lower than 85 rupies and will typically become the main component of your net profit or loss over your holding period. Both dividend payments and proceeds from sale of your shares will end up in your brokerage account and can then be transferred to your bank account if you so desire.


Anonymous Anonymous said...

Market risk is perceived to be the price we are required to pay to enjoy the higher long-term returns historically available in common stock investing. Prudent investing, however, does involve trying to reduce idiosyncratic risk - that is, reducing the risk inherent in the ownership of individual securities. The definition of quantity theory of money is the proposition that a change in the growth rate of the money supply brings an equal percentage change in the inflation rate.

11:29 AM, June 25, 2007  
Anonymous Anonymous said...

When looking at PE ratios for an indication of value, one must be aware of what type of company he is examining and at what point in the buisness cycle we are in. Low PE's or PEG's are often a sign of value in classic growth companies. However when looking at cyclicals it is often near the top of the cycle when companies look very cheap. This is evident when looking at commodity based industries like oil or steel where so much of their earnings are based on that commodities curent price. When the commodity is low priced, the stocks will sport high PE's due to the absence of earnings. But when the price of the commodity goes up, earnings follow and PE,s go down. When looking at cyclicals past performance the stocks will boost high PE,s right before big moves up and low PE's right before big moves down. If determining value was as simple as looking at a PE or PEG ratio, we would all be rich.

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Anonymous Anonymous said...

Adding the G in PE calculation is a really good idea. I have always used PE more as a filtering criteria rather than a selection criteria. By its very definitionP/E helps tell you what stocks are really expensive, so you can avoid them and filter them out. But adding G will help determine whether it is attractive enough to really buy into.
Thanks for your insight into this!

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