Penny Sleuth Analysis of P/E Ratios

Appetite for Destruction
May 25, 2007
 

Each morning I pick up the Financial Times and turn to the back of the Companies & Markets section to check in on world equity markets at a glance. I scan every major international index for stocks with single digit P/E ratios.

The theory is simple: I’m scanning for companies with exceptionally strong earning power. You can roughly estimate a company’s earning power per share by taking the inverse of its price/earnings ratio. A stock with a P/E ratio of 8 can be said to have earning power of 12.5%.

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Benjamin Graham points out that there’s a margin of safety in an expected earning power considerably above the going rate for bonds. So a 12.5% earnings yield on the stock offers you the investor a 7.5% average annual margin over the 4.85% bond rate.

So after finding 10 or so stocks, I would jump to the other side of the page to compare these earnings yields to the returns offered on their respective benchmark government bond. If I found a decent spread, I would dig deeper.

That’s a simple approach any reader can do over some wheat toast and a cup of coffee.

So it struck me yesterday as I was working my way from Taiwan to Thailand that the number of single digit P/E ratio’s across the globe has dwindled dramatically. Finding multiple securities that fit the bill used to be an easy task, especially in cases like Thailand and Israel where political risk carried significant weight. South Korea also offered up its fare share. But that’s no longer the case.

There were less than 80 today. And most of that bunch snuck in the 9+ category. Hardly the impressive double-digit earnings yield I’m looking for.

I equate this phenomenon to something Eric Fry touched on in yesterday’s Rude Awakening. And the cause, broadly speaking, is “liquidity.”

Eric points out, “Simply defined, it is that vast pool of cash, credit and derivatives that animate financial asset prices… All the world’s major financial assets, therefore, are floating on the same vast sea of liquidity -- U.S. stocks as well as Chinese stocks, Kansas farmland, Brazilian bonds, and yes, even gold.”

The point is, the world’s sudden appetite for risk seemingly knows no bounds. This seeming impenetrable attitude has combined with mounds of excess cash to catapult stock prices across the globe well over the 20 times earnings mark. And I’m not just talking about emerging markets either…inflated asset appreciation is taking place in mature markets like Japan, Hong Kong, Switzerland and the United States. All four markets have P/E ratios above 20.

A price-to-earnings ratio of 20 offers a 5% earnings yield, or roughly, the same earning power as a government bond except these stocks carry significantly more risk. 

Remember, successful investing will require a combination of patience, realistic expectations and, most importantly, buying shares of businesses at the right prices. I can’t stress that enough.

As investors, we’re looking for a margin of safety…companies trading near or below their intrinsic value with an established earning power.

That’s basically it. 

It doesn’t take a financial genius to recognize that the Chinese market can’t go up forever… So brace yourself for the inevitable fall…it doesn’t take a white-shoed, Wall Street banking analyst to realize that shares of Bank of China shouldn’t trade for 35 times future earnings.

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Mark Twain once said: “History doesn’t repeat itself, but it often rhymes.” That’s certainly true. But I doubt even he could imagine our tendency to repeat the same reckless behavior by paying too much for securities would happen so quickly. Our appetite for greed equals our appetite for destruction.

And even despite even our most blatant examples of irrational market exuberance (dot.com land, sub-prime lenders, etc.), many investors are already aggressively making the exact same mistake all over again by simply paying too much for a business.

They fool themselves into believing that there’s a greater fool prepared to pay an even greater price. They rationalize their behavior by saying it’s different this time. It’s never different this time.

But around and around we go.

Until Next Time,
Christopher Hancock

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