Tuesday, June 07, 2011

The Many Faces of PE - Growth

This is a continuation of the previous post on the many ways to look at the PE ratio.

3. Growth Angle

As the investment world, led by brokers shifted to look at just 1 year PE ie PE using next year's earnings. A lot of imagination bloomed on how we can interpret this ratio. The most popular one being how PE can be used to tell the growth story. The rationale is simple enough: different companies and industries have different growth outlook. By looking at next yr's PE, we cannot just say that: ok, more than 15x is expensive, I am not going to buy anything more than 15x.

What if the industry is growing at 30% per year? Then 15x is cheap! By right, it should trade at 30x PE (see the rule of thumb below). Hence with this argument, basically the brokers can convince anyone to buy at any PE. The most recent case being Facebook, our most visited website nowadays. Facebook is being valued at USD 65bn, but its revenue is USD 1bn and profits probably half of that. This means that Facebook's PE is roughly 120x, yet investors are asking for more, they can't wait to buy it bcos on its first day of trading, it is bound to go up another 50%, ie its PE will hit close to 200x!

Well's that's the Greater Fool Game for you in Font Size 64.

But, back to reality, since the whole world looks at just next yr's PE, and it is the most accessible ratio, when we look at that number, we can also incorporate this growth angle mentality.

Basically the way I would look at it would be as follows (all based on just next yr's PE:

10x: either very cheap or the industry has no growth. Some telcos, nuclear stocks, dying industries trade at this PE

15x: Fairly valued, or cheap if growth is good (ie more than 20%).

20x: Expensive, very highly likely to lose money if we buy anything at 20x. The growth has to be 25% or more to justify this PE ratio.

25x: Nothing should trade above this (by right), no matter how good the prospects are. Think thrice if you want to buy a stock trading above 25x and then don't buy it. For more on this point, see this post: Valuation Expansion.

It is also industry rule of thumb to pay x multiple of x% of growth, ie if a stock is growing 15% we can pay 15x for it. There is no mathematical proof or strong financial concept behind this interpretation. It is, in every sense, just a rule of thumb. Some investors use this rule quite often. Even the value guys.

Of course this rule of thumb falls apart when the PE is too high or low. For eg, companies with no growth trades at 10x (usually), while Facebook which can probably grow 30-40% trades at 100x.

Hence I would usually demand more growth given the same PE. ie for PE 15x I hope to get 20% growth.

Next post: Quality!
Post a Comment