Price earnings ratio is widely and commonly used in determining if a stock is over or undervalued. However, it may be quite difficult to use. PE ratio has some inherent pitfalls. For example, cross-section comparison can be a bit difficult. Different sectors have different PE ratios. Utility companies, for instance, are known to have low PE ratios, while telecomm/technology companies are believed to have high PE ratios. It also, does not factor in dividend investors and the underlying PE assumption that share price is driven by future earnings may not be applicable in some sectors.
Basically, price earnings ratio, expresses the relationship between current stock market price per share and the reported yearly earnings per share; usually of the last quarters. It derived its meaning from the payback multiple, which is the time it will take to recover one’s investment. It also, shows what the market or investors are willing to pay today for a stock based on its past and future earnings. Hence, it helps investors determine the price of stock compared to the earnings of the company.
For example, assuming GTB and Access bank current share price are N26.65 and N7.40 respectively, while their basic EPS are GTB – N1.58 (2018) and Access Bank – N3.13 (2018). It means GTB’s PE ratio is 16.87x (26.65/1.58), while Access Bank is 2.36x (7.40/3.13)
From above, this could mean that GTB investors expect higher earnings compared to the market or Industry and so willing to pay more than Access Bank investors or that GTB stock price is high relative to earnings and possibly overvalued. But that may not mean that GTB stock is a better stock than Access Bank stock.
To actually get a better perspective, certain fundamentals are to be taken consideration. These fundamentals influence or drive the Earnings multiple and include payout ratio, expected growth rate, return on equity, interest rate, risk, etc. Let us take these fundamentals one after the other.
- An increase in expected interest rate will increase return on equity and invariably lowers P/E ratio.
- An increase in return on equity will lead to rise in payout ratio for any given growth rate and thus a higher P/E ratio.
- Lower risk premium as a result of investors’ willingness to take risk will result in higher P/E across all stocks.
- P/E increases as expected growth increases. The higher the P/E ratio and the effect of changes in expected growth rate varies, depending on the level of interest rates. The P/E is much more sensitive to changes in expected growth when the interest rates are low, than when they are high. This is because growth produces cash flows in the future and the present value of these cash flows is affected by the interest rate and the higher the interest rate the lower the cash flows.
Therefore, it may be difficult to draw conclusion about the P/E without looking at these fundamentals as P/E ratios of firms vary across time, markets, industry and companies, due to these fundamentals.
Though some analysts compare P/E of a stock against its historical average and/or industry average to determine if the stock is over or undervalued. If the stock is trading higher than historical average and/or industry average, then the stock is overvalued.
On a face value and using our two banks; Access bank and GTB are in the same sector and holding other fundamentals constant, Access bank, with lower PE ratio compared to GTB, one can assume that Access bank stock is undervalued. Under normal investment principle, if stock is undervalued, you go ‘long’ that is buy and if overvalued, you go ‘short’ that is sell.
Apart from using PE ratio, earning yield can equally help to determine if a stock is over or undervalued. A low price earning stock is also an attractive alternative to investing in lower treasury bills/bonds yields. This is possible because low P/E stock has high earning yield (EPS/MPS). Earning yield, which is the inverse of Price Earning shows the percentage of each Naira invested in the stock that was earned by a company. The earning yield is usually used to determine the optimal asset allocations. This is done by comparing it to a broad base interest rate such as Treasury bonds, index, such NSE, etc. If the earning yield is less than the rate, for example a 10-YR bond yield, the stock may be considered overvalued. If the earning yield is higher, the stock may be considered undervalued relative to the bench mark (Bond or Index.).
Let us still use of sampled stock for illustration.
|S/NO||COMPANY||SHARE PRICE||EPS||P/E||EARNING YIELD|
|1||Guaranty Trust Bank||26.65||1.58||16.87||0.06|
From above, Access Bank has a better earning yield (42%) compared to GTB (6%). These rates can then be compared to treasury bills/bonds yield. If the Earning Yield is higher than the treasury bills/bonds yield, then the stock is undervalued, you can take a long position on the stock.
Comparing the earning yields of these stocks for example, with the October 23, 2019 auctioned 10-year FG Bond at 14.55%, assuming yield eventually is 14.55%, Access bank stock is undervalued compared to the referenced bond, while GTB is overvalued.
Equally too, price earnings growth ratio (PEG), which is an improvement of PE ratio can be used to determine if stock is over or undervalued. It shows the relationship between PE ratio and a company’s earnings growth rate. PEG ratio just like PE ratio assumes that share price represents stretch of future earnings.
The assumption is that, If PEG = 1, the stock is fairly prices; <1, it is undervalued (buy) and >1, sell and >2 strong sell, which means you are paying much based on the EPS growth at the current/buying stock price.
Using our two banks (GTB and Access Bank:
|S/NO||COMPANY||SHARE PRICE||EPS (2017||EPS (2018)||EPS GR||PE RATIO (2018)||PEG|
|1||Guaranty Trust Bank||26.65||1.47||1.58||7%||16.87||2.41|
Combination of PE and PEG ratios will further confirm if a stock is cheap or not holding constant other variables as well as the inherent pitfalls already highlighted and relying on that, Access bank is better priced. Please note that this write-up/opinions espoused here do not constitute recommendation for the purchase or otherwise of any of the stocks.