Stocks trading at the same price earnings multiple are not the same

12 May Stocks trading at the same price earnings multiple are not the same

As published in Citywire on 12 May, 2021 by Pieter Hundersmarck

Investors can be fooled into buying stocks on a low P/E without taking into account the much lower growth that these stocks offer

In a bull market, stocks are priced using PEG ratios, and in a bear market they are priced on PE ratios.

Both are useful. The PE ratio compares the price of a share to the earnings that share is expected to generate over the following twelve months. It illustrates the relationship of a share price to a measure of value (in this case earnings per share).

Price to earnings multiples can tell us what the market thinks of a business. If stock A trades at 12x earnings per share and stock B at 24x earnings per share, the market believes that the earnings per share of Stock B is worth twice that of Stock A. The two main reasons for this are the quality of those earnings and the growth rate of those earnings.

PEG ratios (the price earnings ratio adjusted divided by growth) can be a useful sanity check on valuations. It combines the PE ratio with the expected growth trajectory of earnings per share, allowing us to compare 2 shares that have the same PE multiple, but different growth profiles.

In the table below I’ve averaged the next two years EPS and used next year’s PE (all Bloomberg consensus) for a range of popular ‘blue chip’ consumer stocks.

All of these companies are undoubtedly high quality. They own top quality brands, have geographically diverse operations, deliver high profitability, attract the best management teams and generate large amounts of free cash flow. They have also been around for a long time (although in different form) implying a high level of resilience.

But how many of these high-quality traits are unknown by the market? I’d wager very few. The price earnings multiple of 22.7x (higher than their long run average) tells me that the quality attributes are no secret.

The PEG ratio is useful here. The median growth rate in EPS for the selection of consumer names in the table is 7.2%. When comparing the PE multiple to the growth rate we arrive at median PEG of 3.3x.

Below is same table, but this time using online gaming businesses instead of consumer stocks. The median PE ratio of 23.4x is very similar, but the expected growth rates are far greater, leading to a median PEG ratio of 1.5x – nearly half the 3.3x offered by the consumer names.

The PEG tells us that for the same price, you can buy double the growth. But perhaps the quality of the earnings from the online gaming companies is lower?

Not so in our view. The online gaming companies are also of undoubtedly high quality. They own top quality gaming franchises, deliver even higher profitability, attract the best management teams and generate even larger amounts of free cash flow than consumer companies. They have also been around for decades and operate in much faster growing markets than the afore mentioned consumer companies.

As the example shows, investing purely on the basis of PE can be treacherous

Using the PEG ratio is good barometer of what is expensive or cheap relative to growth. Anything valued higher than 1.5x PEG needs a good reason, and any below that look interesting. It’s also a useful metric to compare stocks to each other.

Consumer names are extremely expensive versus their own history, as well as their growth prospects. Not only are they expensive, they are highly negatively correlated to rising bond yields. The same cannot be said of a selection of high quality online gaming stocks.

About Pieter Hundersmarck:

Pieter is a fund manager and member of Flagship’s global investments team.

Pieter has been investing internationally for over 13 years. Prior to Flagship, he worked at Coronation Fund Managers for 10 years in the Global and Global Emerging Markets teams, and also co-managed a global equities boutique at Old Mutual Investment Group. Pieter holds a BCom (Economics) from Stellenbosch University and an MSc Finance from Nyenrode Universiteit in the Netherlands.