Central to our investment philosophy at Allan Gray is buying shares that the market has priced below what we believe they are worth. We then sell these shares when they reach our estimate of a fair price. We arrive at our assessment of a fair share price by thoroughly researching all aspects of a company. One of the factors we consider is the 'price-to- earnings' (PE) ratio. Wanita Isaacs explains this concept.
A PE ratio helps to assess value
The PE ratio is what investors are willing to pay for a rand of earnings. To get the PE ratio you divide a company's share price by its earnings per share (EPS). Price means the actual price of the share on the stock exchange at a given point in time and represents what investors are willing to pay for that company. EPS represents the portion of the company's profits allocated to each share, i.e., the total profit divided by the number of shares in issue. If a company's share price is R120, and its EPS is R10, its PE would be R12. This means an investor would be willing to pay R12 for R1 of earnings. It is important to note that the PE is based on historic earnings.
The concept of normal earnings
One of the problems with taking a PE based on historic earnings at face value is that profits can be cyclical. For example, a commodity company that reported profits for the year ending six months ago would have earned these profits on commodity prices that are now, on average, 12 months old. If the commodity price has changed over the last 12 months, its current profit run-rate could be very much higher or lower than the last reported numbers, and the market would try to anticipate this change in the share price. This adjustment for anticipated changes in earnings would appear as a high or low PE.
Therefore, instead of using actual earnings, we prefer to assess the level of profitability and profit growth we think is sustainable over time, which we refer to as 'normalised' or 'trendline' earnings. This allows us to separate out two factors in estimating a share's fundamental value: our estimate of future earnings, and the price we would be prepared to pay for each rand of those earnings.
Ignoring the impact of short-term changes to profit, a higher PE ratio indicates perceived better growth prospects, or less risk to profits, than the average company. Thus, absent other factors, a company with a proven long-term track record of growing profits would normally trade at a high PE ratio and a company with low growth, or a patchy profit history, would trade at a lower PE ratio. Poor reporting, transparency or governance may affect investors' perception of risk and thus reduce the PE ratio they are prepared to pay for earnings.
Context counts
We also consider PE ratios in context. Firstly, we look at what other investments are available at the time. Interest rates on cash are low and the prices of bonds and property funds are high, and this may explain why current PE ratios are also high.
Secondly, we consider at what PE we think we may be able to buy or sell a share in the future. The long-term history of the FTSE/JSE All Share Index (ALSI) is shown in Graph 1. The trendline PE for the ALSI is currently 21x, well above the long-term average of 12x. Holding cash, even when it is not paying very much in interest, lets us buy shares in the future when they return to more normal valuations.
What can you do?
A 'balanced' unit trust, where the investment manager looks for the best value investments across different asset classes on your behalf, can provide you with some comfort, and protection from dramatic fluctuations in return. However, in an environment of high prices, you should still prepare yourself for less exciting returns that we have seen in the past.