What does “cheap” mean?
Recently, I was asked what I meant when I said a stock is cheap.
Here follows a short and I hope, simple explanation of the basics. There will be more to follow!
Price Earnings Ratio:¬†
Perhaps the most common way of valuing a share is the Price Earnings Ratio or PE Ratio.
The earnings of a company are its post-tax profits. To calculate earnings per share, one must divide the earnings by the number of shares in issue.
The price-earnings ratio is simply a matter of dividing the current share price by the earnings per share. So, if Company “A” has a share price of 100p and last year it made earnings per share of 10.0p, the historic PE Ratio is 10.0x. Historic because the earnings per share figure are what it achieved in the previous year.
If the consensus forecast, (the average or median) of all brokers‚Äô forecasts is that in the current year it will make 12.0p of earnings, then the Forecast PE Ratio falls to 100p / 12p = 8.3x.
The big question is, does that make¬†Company “A” cheap or expensive?
This is where one starts to compare its valuation with that of the market as a whole and perhaps other stocks in its industry or sector.
According to Stockopedia the PE Ratio of the median company of all the stocks in the UK is currently 16.2x and the median forecast earnings growth is 16.0%. Therefore, if you bought a basket of all the stocks in the UK market you would be paying 16.2x for 16% earnings growth.
How does Company “A” compare? All things being equal, Company “A” looks cheap. One is only paying 8.3x forecast earnings for 20% earnings growth. One would hope that as this anomaly is recognised by more investors they will buy. More buyers than sellers should force the price up. For it to be on the same PE Ratio as the market the share price would need to go up 94% to 194.4p, (194p / 12p earnings forecast = 16.2x PE Ratio).
PEG Ratio: Price Earnings Ratio / Earnings growth rate¬†
Taking this further, one might argue that as earnings are growing faster than the market it should command a higher valuation. This is where the PEG Ratio (PE Ratio¬†/ by the growth in earnings per share). In our example, the market is on PEG Ratio of 16.2x / 16% growth = 1.0125. Company “A” after its 94% jump to 194p is on a PEG Ratio of 16.2x / 20% growth = 0.81. For it to be on the same PEG Ratio as the market, the share price needs to rise further to 243p, (243p / 12p = PE Ratio of 20.25x and then, 20.25x / 20% earnings growth = PEG Ratio of 1.0125) So, Company” “A at 243p is valued at the same level as the wider market, adjusted for its faster rate of growth.
All things are rarely equal
All things being equal, Company “A” looks outstandingly cheap at 100p, but all things are rarely equal.
One must consider the balance sheet and the Quality of the business. If the 20% earnings growth forecast for Company “A” in the current year is likely to be a one-off, due for example to a temporary drop in the oil price, (its main input cost), the market is likely to be wary and not push it all the way to 243p. Perhaps sellers will decide it deserves to be valued at a 20% discount to the market, despite this year‚Äôs superior growth. So, 20% discount = 0.8 x 16.2x (market PE Ratio) = 12.96x. 12.96 x 12.0p earnings per share = 155p. Still a good return on a 100p purchase price. As an investor, you have to make that judgement.
The company might also be highly indebted, leading to the risk¬†that in a bad year, it will not be able to meet its obligations to¬†its banks/lenders. This might be another reason to afford it a discount to the market as a whole.
Dividend yield as a valuation tool
Companies often pay dividends out of their earnings. The Board will consider how much it can afford to pay out in dividends to its shareholders, after holding back enough cash to meet future obligations and plans. It might decide it can only afford a small dividend because it would like to pay down debt or because it wants to fund a new factory.
Back to Company “A”: If last year it paid a dividend of 5.0p per share out of its earnings per share of 10p, the historic dividend yield at 100p would be 5.0% (5.0p / 100p). If the market forecasts that it will grow the dividend in line with its earnings this year, the dividend would grow to 6.0p (5.0p x 20% growth). 6.0p / 100p = a forecast yield of 6.0%.
According to Stockopedia the median forecast of all dividend payers in the market bis currently 3.0%. One might judge¬†that taking everything into account, (factors such as¬†the sustainability and future growth of the dividend) that Company “A” should be valued on the same forecast dividend yield as the market. To be valued at a 3.0% forecast yield the share price would have to double to 200p, (6.0p / 200p = 3.0% forecast yield).
All things are rarely equal II
Would one prefer a company on a 2.0% dividend yield growing at 20% per annum for the foreseeable future or one on a 4.0% yield growing at 4.0% for the foreseeable future? I would suggest the lower initial payer is best. Not only will it be paying a higher dividend within four years but if the market is still valuing it at 2.0% yield, as it expects the faster growth to continue, the share price will have increased 2.5x. (At start a 2.0p dividend / 100p share price = 2.0% yield and five years later a 4.97p dividend / 248.5p = 2.0% yield). The 4.0% yield stock‚Äôs share price will have only grown by 21.5%, to maintain a 4.0% yield!
Price to Free Cash Flow
Free Cash Flow is what is leftover from its operating cash flow after it has paid for capital expenditure within the business. This is essentially cash that the Board can use to reward shareholders with dividends, pay down debt (if any) or invest in future growth or squander on a poor acquisition! Higher free cash flow is better.
As a rule, highly capital-intensive businesses, which need to keep investing in new plant, are unlikely to generate as much free cash as a business with high returns and low Capex requirements.
Share price to free cash flow ratio is a ratio I look at as it can be more instructive than the PE Ratio. A stock might look cheap on PE ratio but if the free cash flow ratio is very high or non-existent, it tells you that although earnings per share might be fine, the free cash being generated is not.
Remember the saying, “turnover is vanity, profit is sanity and cash flow is reality!” ¬†
Two examples from the JIC Portfolio:
Venture Life Group.
When I added VLG to the portfolio back in May, I concluded¬†‚ÄúThe shares have drifted back over the last week, giving what looks like a reasonable entry point. In short, the valuation looks very attractive for what should be a good short, medium and long-term growth story. The balance sheet is strong. It feels to me like a ‚Äústock for all seasons‚ÄĚ. I‚Äôm settling for Medium Risk/High Return, pointing to a 4.0% position but to will start my position today at 2.0%.¬†¬†It is very narrowly traded and tends to move on little volume.¬†‚Äú
On Valuation, I said:¬†On current forecasts for the year ending December 2020 the shares are valued at 15.1x earnings. That looks super value for earnings growth of near 100% from 2.18p to 4.05p. Next year earnings are forecast to be flat. That seems far too pessimistic to me. Forecasts have been upgraded over the last few months; In December, forecasts for 2020 were for 3.24p, they are now 4.05p, (according to Stockopedia and ShareScope)
At that time, it was valued at a similar PE Ratio to the market, but the earnings were growing rapidly. Given the balance sheet was fine, (with net cash) and that I expected earnings forecasts to be upgraded again, a PE ratio of 15.1x left scope, in my judgement, for a rerating towards to 20.0x. Also, there seemed little downside risk.
Moving on to the present, we have had several upgrades since May and valuation on 19th November 2020, looked like this:
The first thing to note is that earnings per share forecast for 2020 is now 5.04p, up from 3.24p forecast in December 2019 year and 4.05p forecast at the time of my initial purchase in May this year.
This chart from Stockopedia shows how earnings forecast have been upgraded.
The current valuation is a PE Ratio of 22.8x 2020 earnings, so quite a premium to the 16.2x for the market. Why am I not selling? First, I think the earnings for 2020 may well be upgraded again so that it is not really on 22.8x but something less. Also looking at 2021, it is valued at 19x for 19% earnings growth. Not so bad as I expect that 2021 forecast may also be too low. ShareScope has a 2022 earnings per share forecast of 6.3p putting it on 18.2x that years forecasts.
I have made good money so far as I have had investment nirvana of a ‚Äúdouble whammy‚ÄĚ; a rerating (from 15.1x 2020 forecasts to 22.8x) on upgraded earnings forecasts (4.05p to 5.04p).
Why do I still like it? I think there is scope for a further re-rating perhaps to 25.0x and that earnings per share forecasts will see further upgrades. And, I have written all that without mentioning Dentyl! (Being able to put ‚Äúclinically proven to destroy coronavirus‚ÄĚ on its label could do wonders for sales.)
Venture Life Group: Dividend Yield. It currently does not pay a dividend. It has found more attractive uses for its spare cash, investing in growing the business, than paying dividends. That‚Äôs fine by me, and by the looks of things the market.
It has been investing in the growth of the business which means, as the table below shows, that up until 2019, free cash flow was negative. In 2019 however, increased operating cash flow from the business of 2.73p per share, (earnings per share were only 1.17p in 2019) more than covered Capex of 1.28p per share leaving free cash flow per share of 1.45p. It will be interesting to see what free cash flow is in 2020.¬†¬†ShareScope‚Äôs forecasts suggest it will start paying a dividend of 0.53p in 2022.
Note: It has a June year-end.
I added this stock in September 2019 at 36.5p. On valuation, I said:¬†¬†It started paying a dividend last year (June 2019) and for the year ending June 2020 is on a prospective dividend yield of 4.8%. It is on a prospective PE ratio of 5.0x,¬†(earnings per share forecast of 7.3p)¬†for 44% forecast earnings growth in the current year.
Forecasts for June 2021, the year we are currently in, are for 40% earnings growth to 23.4 US Cents or 18p. At the current price of 78p that puts it on a prospective PE ratio of 4.5x. It will never be at a premium given the exposure /dependency on PGM prices, but that discount looks too wide. Especially when we look at cash flow.
Please Remember: Not advice, just an entry in my investment diary!
All the tables above came from Stockopedia¬†and the two charts from ShareScope
I hope this has been helpful to those just starting their investment journey.¬†
I will write further sections and answer any questions on this post and¬†on other topics and valuation metrics such as Price/Book value, Enterprise Value/Sales etc.etc.