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    Valuation Evaluation Using Price-Earnings Relatives

    by Wayne A. Thorp

    The price-earnings ratio (P/E)—or earnings multiple—is one of the most popular measures of company value. It is the current stock price divided by earnings per share for the most recent 12 months.

    The popularity of the price-earnings ratio stems from how it relates the market’s expectation of future company performance—embedded in the price component of the equation—to a company’s actual recent earnings performance. The greater those expectations, the higher a multiple of current earnings investors are willing to pay for the promise of future earnings.

    But price-earnings ratios are not across-the-board comparable in terms of value. How, then, do you judge whether a company’s price-earnings ratio represents good value?

    There are models that help gauge if a company’s price-earnings ratio is reasonable. The relative price-earnings ratio approach looks back at the relationship of the price-earnings ratio of a stock either to the price-earnings ratio of the overall market or to that of the company’s industry.

    Price-Earnings Relative

    The price-earnings relative is determined by dividing a company’s price-earnings ratio by that of the market. A price-earnings relative average above 1.00 would indicate that a company’s price-earnings ratio is typically above the market’s price-earnings ratio, and vice versa. Based on relative growth and risk expectations, companies trade at multiples greater or smaller than that of the market multiple. One would expect a company with prospects better than the market, or with lower risk, or both, to have a higher price-earnings ratio than the market. Comparing a firm to its industry is an equally useful technique that has the benefit of isolating interesting candidates within a specific industry.

    Publications such as Value Line publish relative price-earnings ratios, but you can also calculate the figure yourself. The following is a summary of the process. For a more detailed explanation, with numerical examples, please refer to the Stock Screens area of AAII.com.

    Using Stock Investor Pro, AAII’s fundamental screening and research program, “market” price-earnings ratios are calculated for each of the last five years, which are then used to calculate annual price-earnings relatives for individual companies for each of the last five years (in order to calculate a price-earnings relative value, a company must have positive earnings). Based on these annual price-earnings relative values, we arrive at a five-year average price-earnings relative value for the company.

    Multiplying the price-earnings relative by the market’s current price-earnings ratio provides an adjusted price-earnings ratio. The assumptions behind this model are that the market is fairly valued, which is not always the case, and that the company’s relationship to the market has not changed.

    A stock price valuation can be determined by multiplying this adjusted price-earnings ratio by the company’s trailing 12-month earnings per share. Dividing the current share price by the valuation provides a useful screening measure; 1.00, or 100%, indicates that the valuation and current stock price are equal. Figures above 100% may point to prices above valuation estimates, while figures below 100% may highlight undervalued companies.

    The P/E Relative Screen

    AAII has developed a screen based on this price-earnings relative that seeks stocks that have:

    • A current stock price below its price-earnings-relative-adjusted valuation;
    • Recent upward revisions in annual earnings estimates;
    • Recent increases in annual consensus earnings estimates.

    Screen Performance

    Figure 1.
    Performance of
    Price-Earnings
    Relative Screen
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    The price-earnings relative screen is built into Stock Investor Pro. In addition, the companies passing this screen are posted each month on AAII.com and the performance of these stocks in a hypothetical portfolio is tracked on-line.

    The price-earnings relative screen has outperformed the large-cap S&P 500 index and other broad market indexes since the beginning of 1998. Over that period, the screen has posted only one down year, which was 1999.

    Figure 1 shows that the price-earnings relative approach has generated a cumulative return of 355.9% over the period from January 1998 through September 2006, while the S&P 500 is up 37.7% over the same period.

    Profile of Passing Companies

    The characteristics of the stocks currently matching the price-earnings relative criteria are presented in Table 1.

    While the price-earnings relative approach does not contain explicit “value” filters that you may be more accustomed to, it is seeking undervalued stocks. In this case, the methodology identifies companies trading at no more than 75% of the valuation derived from the company’s price-earnings relative ratio. As a result, it is perhaps not surprising to see that the median price-earnings ratio of 13.5 for those companies currently passing the price-earnings relative screen is below the median value for all exchange-listed stocks of 19.7. However, the median price-to-book-value ratio for the price-earnings relative stocks is 3.1, while the median value for exchange-listed stocks is 2.1. Given the cap that the price-earnings relative methodology places on the current stock price as a percentage of the price-earnings relative valuation, the median value for the companies passing the price-earnings relative approach is 59.7%. In contrast, the median value for exchange-listed stocks is 91.7%.

    The price-earnings relative screen does not require minimum historical or expected growth rates, but the stocks currently meeting the criteria of this methodology match or outperform those of the typical exchange-listed stock. The median five-year earnings per share growth rate for the price-earnings relative stocks is 21.9%, as compared to 11.5% for exchange-listed stocks. The median market capitalization of the price-earnings relative stocks is $2.4 billion, compared to only $448.9 million for all exchange-listed stocks.

    The companies currently passing the price-earnings relative screen have outperformed the S&P 500 by a median value of 8% over the last 52 weeks. Meanwhile, the typical exchange-listed stock has underperformed the S&P by 3% over the same period.

    Finally, there are 17 stocks that meet the price-earnings relative screen criteria, which is well below the monthly average of 35 passing companies since the start of 1998. This methodology also has a fairly high monthly turnover, with only 23% of the stocks passing the screen month-to-month.

    Table 1. Price-Earnings Relative Portfolio Characteristics
    Portfolio Characteristics (Median) PE
    Relative
    Exchange
    -Listed
    Stocks
    Price-earnings ratio (X) 13.5 19.7
    Price-to-book-value ratio (X) 3.1 2.1
    P/E rel adj price-earnings ratio (X) 26.6 20.5
    EPS 5-yr. historical growth rate (%) 21.9 11.5
    EPS 3-5 yr. estimated growth rate (%) 14.5 14.4
    Price as % of P/E rel valuation (%) 59.7 91.7
    Market cap. ($ million) 2,438.30 448.9
    Relative strength vs. S&P (%) 8 –3
    Monthly Observations
    Average no. of passing stocks 35  
    Highest no. of passing stocks 110  
    Lowest no. of passing stocks 2  
    Monthly turnover (%) 77  

    Passing Companies

    Table 2 lists the 17 companies that passed the price-earnings relative screen as of October 6, 2006. The companies are ranked in ascending order by price as a percentage of the price-earnings relative valuation (the last data column). To arrive at the valuation, the earnings per share for the last 12 months are multiplied by the adjusted price-earnings ratio.

    Freeport-McMoRan Copper & Gold, which engages in the exploration, mining, and production of copper, gold, and silver, tops the list with a current stock price that is only 32.9% of its price-earnings relative valuation. K-V Pharmaceutical Company, a specialty pharmaceuticals company, just comes in under the 75% cap at 74.8%.

    Freeport-McMoRan’s price-earnings ratio of 8.8 is below the 13.5 median for the firms in Table 2, but slightly lower than the metal mining industry’s price-earnings ratio of 11.2. The opposite can be said for K-V Pharmaceutical, at the bottom of the list—its current price-earnings ratio of 28.1 is twice the median for the current passing companies and is fractionally higher than the biotechnology & drugs industry’s price-earnings ratio of 26.3.

    Interestingly, both companies have similar expected growth rates—26.0% for Freeport versus 25.2% for K-V Pharmaceutical. However, the financial success of mining companies is highly correlated with commodity prices, which are highly cyclical in nature. As a result, given the lower multiple at which Freeport trades, the market may feel that it has a higher risk of an earnings slowdown compared to K-V Pharmaceutical.

    Price momentum is often used as a signal that the market has recognized the stock price is reacting to either proven performance or an increase in expectations. The current market price as a percentage of the 52-week high price is a popular measure of price strength or momentum. Financial services company Morgan Stanley has been a strong performer of late, with its closing price on October 6, 2006, within pennies of its 52-week high. In contrast, Oil States International, a provider of products and services primarily related to offshore oil and gas drilling, hit a new 52-week low in mid-September.

    Investors often look for a catalyst to help attract attention to a company and boost its stock price. The prices of many attractively priced stocks often languish until investors find a reason to re-evaluate the prospects of the firm or its industry.

    Upward earnings revisions are events that make investors take notice of a company. Revisions in earnings estimates lead to price adjustments and when earnings estimates are revised significantly, stocks tend to show above-average performance. Stock prices of firms with downward revisions tend to show below-average price performance following the adjustment.

    The price-earnings relative screen requires at least one upward revision in the current and next year’s earnings estimates over the last month. It also requires that there be more upward revisions than downward revisions in the current and next year’s earnings estimates over the last month. Lastly, it calls for an increase in the consensus estimate for both the current and next fiscal year over the last month. Intuitively, you may expect that if there has been at least one upward revision and upward revisions outnumber downward revisions, the consensus estimate would automatically increase. However, this is not always the case, as analysts may drop coverage, which could lower the consensus estimate without an actual downward revision.

     

    Conclusion

    Screening for stocks by looking at price-earnings ratios can help highlight firms that have fallen out of favor. Price-earnings relatives establish benchmark comparisons that help identify firms that have deviated from their normal valuation level—with the critical assumption that nothing fundamental to the company, industry, or market has changed significantly. The analysis can highlight companies worthy of further analysis, given the expectation they will move back to their typical levels.

    In constructing screening criteria—especially for value-oriented approaches—you may wish to include a number of conditioning criteria that help indicate items such as the future earnings potential of the firm, the financial strength of the firm, as well as the strength of the firm within its industry. Investing in low price-earnings stocks can be rewarding, but caution is required.

    Finally, it is important to keep in mind that stock screening is only the first step in the stock selection process. The stocks passing the price-earnings relative screen do not represent a “recommended” or “buy” list. It is important to perform due diligence to verify the financial strength of the passing companies and to identify those stocks that match your investing tolerances and constraints before committing your investment dollars.

       What It Takes: P/E Relative Screen Criteria
    • Companies that trade as American depositary receipts (ADRs) are not included
    • Companies that trade on the over-the-counter (OTC) market are not included
    • The average price-earnings ratio for each of the last five fiscal years is less than or equal to 100
    • The current stock price as a percentage of the price-earnings relative valuation is less than 75%
    • At least three analysts provide earnings estimates for the current fiscal year (Y0)
    • The current consensus earnings estimate for the current fiscal year (Y0) is greater than it was one month ago
    • The number of upward revisions in earnings estimates for the current fiscal year (Y0) over the last month is greater than the number of downward revisions in earnings estimates for the current fiscal year (Y0) over the same period
    • There has been at least one upward revision in the earnings estimates for the current fiscal year (Y0) over the last month
    • The current consensus earnings estimate for the next fiscal year (Y1) is greater than it was one month ago
    • The number of upward revisions in earnings estimates for the next fiscal year (Y1) over the last month is greater than the number of downward revisions in earnings estimates for the next fiscal year (Y1) over the same period
    • There has been at least one upward revision in the earnings estimates for the next fiscal year (Y1) over the last month
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