To PE or not to PE*.

"Lab rat" comments:

Surely its necessary to mention PE ratio when talking of share price (SP). My understanding is that its difficult to know what an appropriate PE is for a company like Cellestis because it is growing so quickly and one must factor in the future expectations of the market. I am therefore wondering how people make predictions on share price. 

Not all readers of your blog have a financial/investment background and some light on this subject might be useful.

Let  me start by saying that I am no expert in these matters - just somebody who likes to think about things in a rational and logical manner. That won't stop me from espousing on the matter though.

Like all really good questions, this question doesn't have an easy answer. In fact, the answer will be different for everybody - it depends upon your own views, your own place in life and your own investment/trading aims.


In fact, this question is actually a part of a much larger (but shorter) question - How do you value a share?


If you are a Technical Analyst then you might take a totally pragmatic approach to this question and simply reply that a share is worth what the market will pay for it - now. A really hard core Technical Analyst uses only four pieces of information - Price, Volume, Time and Share Code. They don't care in the least about what the company actually does.


Good luck to them. I'm just not personally comfortable with that approach. 


(The evergreen argument of Technical Analysis (TA) vs Fundamental Analysis (FA) has been done to death over the years and holds no interest for me. In answer to the question "Which is better - TA or FA?" my answer is that it is like asking "Which is better - Football or Hot Dogs?". Both can be found at a football stadium but to trying to compare them is pointless.)


Anyway.


If we are using fundamentals to make decisions about our investments then there are many measures that we can look at - Price/Earnings (PE) is but one of them. Like all good tools, the PE can be used well and it can also be used less well. (Did I tell you about my experience of using a chisel as an emergency screwdriver?).


Mathematically, the PE is easy to calculate. It is just the SharePrice/EarningsPerShare. Expressed in plain language it would be expressed as The price that you are paying for the earnings that can be attributed to your share of the company. It is important to note that this refers to earnings within the company - not return (usually as dividend) that will be paid to you. Of course it is your hope that your earnings that are retained by the company will be used to your ultimate benefit. To deal with that issue we would need to look at Return on Equity (ROE) which I won't do here because it would distract from the simple PE discussion. (If there is any interest I will do a post on ROE at some future time).


Often the PE is defined as being the number of years that it would take for the earnings of the company to equal the price you are paying for the share. That is, a PE of 12.5 means that it will take twelve and a half years for the earnings to add up to the price you paid for the share. Whilst that is mathematically correct, I personally don't like that method of expression - but that's just me - I don't like wearing jockey shorts either.


So, we can easily calculate the PE of a Company. Alternatively, we can decide upon a PE that we would like to see and calculate a Share Price that we would be willing to pay. (SP=PE*Earnings).


How does this help us in our investing endeavours? Evidence that we can easily see tells us that PE is nowhere near the be all and end all guidance to investment choices or decisions. Just have a look at a random selection of companies listed on the ASX. You may find PEs that range from low single digits up into the hundreds. Clearly we cannot just use the PE to blindly compare investment options.


The reason for this is that, in simple terms, the share price consists of two components - a "real definable value" and a "speculative value".


Personally, If I could find a risk free investment earning 8% (that's a PE of 12.5 - work it out for yourself) then I would think that is pretty fair. You might think differently - your decision. But let's use my numbers.


Based upon the Cellestis financials for the half year ending December 2009 it works out this way. Earnings per share were about 3.3c for the half year (extrapolates to 6.6c for the full year) and the Share Price was $3.27. Using the formula above, if we wanted earnings of 8% of our investment, we would be willing to pay (6.6 *12.5) 83c per share (!).


Alternatively (and more usually) we would say that the PE of Cellestis was ($3.27/6.6c) 50. 


Clearly the additional ($3.27 - 83c) $2.44 that we would have to pay for the share if we decide to buy it is speculative or anticipatory value. That is, we would need to have faith that, in time, earnings will grow to make our investment into one that we can own up to our spouse about. For Cellestis, with the above figures, that would mean that earnings have to grow to 27c per year. (I'll come back to this)


Of course all of the above is an overcomplexified analysis of something that is really quite simple. We probably more normally just use the PE as a number to judge what the market is thinking about our potential investment. Clearly, "the market" thinks that Cellestis has a bright future. A useful thing to do with the PE is to use it to compare a company with other companies that we perceive to be similar (but perhaps at a different stage in their lives). We might discover that a cohort of companies that we consider similar to our company seem to run on a long term PE of 22. We might then assume that our Company will eventually gravitate to that PE and make some decisions accordingly. Be careful, though - it is quite easy to end up going around and around in circles (much like the "Whoopsie bird" in the film "Carry on up the Amazon" that spins around and around so fast that in the end it disappears up it's own "Whoopsie" - jeez I'm getting old). 


Now, just coming back to that $2.44 "speculative" value in the share price. Bearing in mind that "the market" is rarely right, it is our job as a potential investor to decide for ourselves if that speculative value is presenting us with a bargain. We don't want "fair" - we want a bargain.


That's when the hard work begins. We need to do the work to understand the company, it's market, it's potential, it's financials etc etc. Then we need to somehow make sense of it all. My preferred tool to bring this all together is a Discounted Cash Flow (DCF) valuation. You can read my explanation of the DCF valuation here.


* I know, they are getting worse.


** I only realised just now that that question is the same one I ask myself about 4am every morning.