CHAPTER 14: THE MILLION DOLLAR QUESTION: HOW MUCH TO PAY FOR IT?

Table of Content

CHAPTER 14: THE MILLION DOLLAR QUESTION: HOW MUCH TO PAY FOR IT?

Previous Chapter
Price-to-Earnings Ratio
Trailing PE and Forward PE
How High is High? And How Low is Low?
Achieved versus Expectation
The Impact of Warrant
Next Chapter

CHAPTER 14: THE MILLION DOLLAR QUESTION: HOW MUCH TO PAY FOR IT?

Price-to-Earnings Ratio

One of the most common valuation methods is the Price-to-Earnings (“PE”) ratio methodology. It is also the simplest. The formula involves dividing the share price of the company with the earnings per share (or EPS) earned by a company.

Price-to-Earnings ratio =	Share Price
	Earnings per share

Earnings per share =	Net Profit
	No. of shares outstanding

The meaning of PE ratio is how many times we are paying for each dollar of profit that a company generates. And if the company pays out all earnings as dividend, how long would it take for investors to recover the cost of investment from the dividend. Take the following as an example:

Table 1: Financial Data of Company A

Net profit (RM)	10,000,000
No. of shares outstanding (shares)	20,000,000
Share price (RM)	2.00

Earnings per Share

= Net profit ÷ No. of shares outstanding

= RM10,000,000 ÷ 20,000,000 shares

= RM0.50 per share

Price-to-earnings ratio

= Share Price ÷ Earnings per Share

= RM2.00 ÷ RM0.50

= 4 times

Notice that both numerator (share price) and denominator (EPS) are in per-share basis. We can also derive PE ratio without using per-share. We can use market capitalisation of Company A (i.e Share price x No. of shares outstanding) divided with Net profit.

Price-to-earnings ratio

= Market Capitalisation ÷ Net profit

= (RM2.00 x 20,000,000) ÷ RM10,000,000

= 4 times

Page BreakIn this case, Company A is trading at PE ratio of 4x. This means that:

Investors who invest in Company A is paying 4x for each dollar of earnings earned by Company A; and

If Company A declares all its profits as dividend every year, i.e. RM0.50 dividend per share, it will take the investors 4 years to fully recover their cost of investment in Company A from Company A’s dividend.

For every RM1 that investors pay for Company A, the return that the investor gets is 25% (derived by dividing 1 by 4).

[1]. Trailing PE and Forward PE

There are two types of PE. One is known as trailing PE and the other is known as forward PE.

Trailing PE is derived using historical earnings, i.e. the earnings of the past four quarters (i.e. adding the profit of the immediate past four quarters to derive twelve months’ worth of profits).

Forward PE is derived using projected future earnings.

Thus, take caution that whenever someone mentions that a certain company is trading at low PE, one must ask whether it is trailing PE or forward PE that the person is referring to.

[2]. How High is High? And How Low is Low?

The next question is what level of PE is considered low and what level is considered as high?

The honest answer is there is no real benchmark to conclude which level of PE is high or low. Take the following as an example.

Company A:

Trades at 4x historical PE ratio.
But earnings expect to be on downtrend due to changes in the nature of industry that Company A is operating in.

Company B:

Trades at 15x historical PE ratio.
Has very strong brand name and is a market leader in the industry.
Very stable revenue growth in the range of 4% to 7% per annum

From the above example, one will find that it is very hard to conclude that Company A is trading at attractive PE multiple whereas Company B’s PE multiple is high.

The key point here is PE ratio alone cannot be used as the sole decision-making factor. A lot of other factors have to be taken into consideration.

[3]. Achieved versus Expectation

Another common tricky question is: How much should we pay for growth?

A trailing PE values the company based on its achieved profit, while a forward PE values the company based on expected profit. And most of the time, the justification to invest in a company is based on growth.

At the initial stage, investment decisions are made based on historical financial data, or earnings. Then came the new investment theory that investment should be based on growth. One of the reasons that sparked this new thinking is that in the 1920s and 1930s, there were companies that went under despite achieving very good historical earnings, which created the conclusion that historical data is not a reliable indication of future prospect.

However, the history of the stock market has also seen an era where growth stocks are bought at any price. The need for justification why some stocks deserve to be traded at high valuation created a new valuation methodology called PE-to-Growth, or PEG ratio.

PEG ratio =	Price-to-Earnings Ratio
	Profit Growth

For example:

Table 2: Comparison of PEG	Company A	Company B
PE Ratio	10x	15x
Earnings Growth	8%	20%
PEG Ratio	1.25x	0.75x

Using the PEG argument, one can say that Company B is trading at “cheaper” valuation than Company A.

In reality, PEG ratio is used when the market cannot find other ways to justify why investors should still invest in a company that is trading at very high valuations. Based on experience, when a company trades at above PE ratio level of above 30x, PEG ratio will be used as the justification as to why the company is still a buy.

I am not saying that it’s wrong or right, but investors have to be cautious when using growth prospect as a determinant of valuation. Though past record is no indication of future performance, neither is growth certain in the future.

So, for growth or not for growth? The best answer comes from Philip A. Fisher:

“Don’t assume that the high price at which a stock may be selling in relation to earnings is necessarily an indication that further growth in those earnings has largely been already discounted in the price.”1

1 Fisher, Philip A. 1996. Common Stocks and Uncommon Profits. New Jersey: John Wiley & Sons.

Page BreakThe answer lies with striking a balance between both. While investment premise must be based on growth, valuation must be supported by the average historical performance. What this means is that investors must take into consideration that:

The growth may not materialise;

The growth achieved may be lesser than what is expected; and/or

There could be a potential of delay in growth (i.e. delay in commercialising of expansion).

The best mitigating factor is that the cost of investment must be supported by the historical earnings.

[4]. The Impact of Warrant

Warrant is a security that offers the holder the rights, but not the obligation, to convert the warrant to the underlying share (or commonly termed as “mother share”) at a pre-determined price (also known as exercise price or strike price). We will explain more on warrant in Chapter 17: Understanding Corporate Exercises.

The conversion of warrants into mother share will result in a dilution of earnings per share of the company. Take Perak Transit Bhd (“PTRANS”) for instance. On 14 September 2017, PTRANS issued 571,474,000 warrants at an exercise value of RM0.235. This means that holders of the warrant can convert his or her PTRANS warrant to PTRANS mother share by paying RM0.235 per share.

Compared with PTRANS’ 1,257,240,000 number of shares outstanding, the conversion of the warrants into PTRANS shares can have a significant dilutive impact. However, on the flip side, since the conversion of each warrant requires payment of RM0.235, PTRANS would be receiving RM134.3 million in cash proceeds, assuming all warrants are converted into mother shares.

I am not implying warrant is bad because it’s dilutive. The message I am bringing is that investors in the midst of analysing the earnings per share have to take into consideration the impact of potential warrant conversion.

The following post next week will discuss about the Concept of Enterprise Value.

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