Since we're talking about the significance of PE ratios, here's an excerpt from Dale Wettlaufer's excellent investment opinion about price-to-earnings growth in the Friday edition of Fool.com's Evening News:
The current P/E of a stock is a shorthand measure that we really should get away from relying on as investors. The P/E is a function of the current value of a company's equity that is derived through models that look at cash flows, economic value added (EVA), net debt (debt less cash), a residual value of cash flows or EVA, and a discount rate. These models indicate an equity value for the company that is then compared to the company's current earnings, yielding a P/E. The fact that a P/E can be observed, that it exists, doesn't validate the existence of the P/E as a predictive measure. It's a descriptive measure, but not an explanatory measure. As a descriptive measure, it's not all that great either.
Let's assume we have a company that we know for certain (because we have a crystal ball that tells us so) will grow its earnings at a 40% compound rate over the next five years. The PEG model would tell us that it would be a buy at 20 times earnings, fairly valued at 40 times earnings, and a short candidate starting at 60 times earnings. If you had bought at those various P/Es and the stock were valued at 20 times earnings five years hence, your compound rate of return over the ensuing five years would be:
20 times...40%
40 times...21.9%
60 times...12.4%
Intrinsic value is accepted by many to be "the present value of a security that offers a rate of return no greater or no less than the market over some ensuing time period." Since the stock market (the S&P 500 being the market proxy, though this is the cream of the crop of equities and has outperformed broader market indexes such as the Russell 2000 and Wilshire 5000) has offered rates of return of almost 20% per year over the last five years. At 40 times earnings, it appears as though the PEG worked. How convenient. However, what happens when the terminal value of the company has changed? Let's re-run the same numbers for two different scenarios:
Stock Valued at 40 times earnings at end of period
20 times...60.8%
40 times...40%
60 times...29%
At all initial valuations, the company has beaten the equity market in general and the S&P 500. True, the lower the valuation, the better your performance going forward, but you could have bought this stock at anything up to 86 times earnings to perform in-line with the market over the ensuing five-year period. Return is still very much a function of the price that was paid, thank you very much, but it's also a function of price at the terminal end of the holding period.
Stock Valued at 14 times earnings at end of period
20 times...30.4%
40 times...13.5%
60 times...4.6%
The stock could have been purchased at anywhere up to 30 times earnings to yield a compound annual return equal to that of the market, before taxes. Again, though, that's backing into what price is right to pay for the company.
To price it correctly, you have to have insight not just into the earnings growth of the company, but you have to have a good idea how it might be priced down the road. How it might be priced down the road will be a function of the future outlook on cash flows, the company's cost of capital, the company's capital productivity, and the growth rate of cash flows. In addition, the PEG and the term "intrinsic value" assume that your opportunity cost of capital, or the return that you forgo when you engage in another activity, is the rate of return of the market. The cost of equity capital really is either the long-run rate of return of the market (about 11%) or the yield on risk-free (U.S. government) bonds with maturities of anywhere from 10 to 30 years plus an equity risk premium times the beta of a particular stock. In the above scenarios, you could have paid ridiculous valuations and still have beaten the market going forward. Such is the gift of growth and such is the fallacy that P/E should equal growth rate or below for a satisfactory return.
Bottom line: once the Street decides that THQ's future is legit and "safe", it will grant it a PE ratio closer to EA. This could start happen any day now. |
