Wednesday, 6 October 2010

P/E and PEG Ratios - Remember the Effect of Interest Rates

Value investors constantly search for under-valued companies and two of the most common metrics to identify such stocks are the Price to Earnings (P/E) ratio and the ratio of P/E to expected future growth rate of earnings (PEG). P/E and PEG are also used to judge whether the stock market as a whole is under-valued.

Wrong Generalizations: One often sees these kinds of statements made about P/E and PEG:
  • low P/E stocks are under-valued, or a lower P/E stock is a better value than a higher P/E stock; a corollary is that when the stock market is above its long-term historical average P/E of 15, it is over-priced.
  • the P/E ratio of a correctly priced stock is equal to its growth rate and therefore when the PEG ratio <>1 the stock is likely over-priced and should be avoided
Beware! Such statements are too simplistic, misconceptions that arise under the assumption of "all other things being equal", which they rarely are. One particular key variable that can substantially affect appropriate values of P/E and PEG (and which seems to receive scant mention in popular media) is the level of interest rates. Let's see how this works.

What is the Alternative? Earnings Yield Compared to Risk-Free Bonds
Turn the P/E ratio upside down into E/P. The E(arnings) can then be seen as simply the profit divided by the P(rice) to pay per share - it gives a percentage return, called the earnings yield, for the stock e.g. a P/E of 20 (which happens to be approximately the current figure for the TSX Composite Index, i.e. the average of all the stocks in the index) is saying that the earnings yield is 1/20 = 5%. If the earnings never change that's what an investment in that stock will provide the investor. A P/E of 15 is thus an earnings yield of 1/15 or 6.7%.

Now, let's bring in interest rates. An investor contemplating buying a stock or a market index ETF (e.g. the TSX index-tracker iShares S&P/TSX Capped Composite Index Fund, symbol: XIC) looks at alternatives. What else is available and what is the yield? The usual reference benchmark alternative is a risk-free long term government bond like a Government of Canada bond maturing in 20 years. If interest rates are low, the investor is satisfied with a lower return on stocks, which means that a higher P/E is acceptable.

Interest rates today are lower than they have been since the 1950s (see this table of Government of Canada long-term bond yields from the Presitigious Properties website). A 20-year Canada bond currently yields about 3.3% per Canadian Fixed Back only ten years ago when such bond rates ranged between 5 and 6%, an investor would have required a higher return from stocks at that time. Since interest rates are currently very low, higher P/E ratios should be expected and acceptable.

Adjusting for Risk
The current bond rate of 3.3% is less than the stock earnings return of about 5%. The question is whether there is enough difference to compensate for the extra risk, of stocks in general, or of a particular stock. For stocks in general, the usual method to get a return is to add a so-called Equity Risk Premium to the risk-less rate. How much should we add? We could take the long term actual historical average of 3.7% for Canada (per the Credit Suisse Global Investment Returns Yearbook 2010). For other countries or the world equity market, historically riskier than Canada, we might take the 4.5 - 5% estimated by Dimson, Marsh and Staunton in The Worldwide Equity Premium: a Smaller Puzzle from the SSRN website). For riskier emerging market countries, it should be higher still. For individual stocks, their relative riskiness would require an upward or downward adjustment.

Inflation is inter-twined with interest rates and risk, having the effect of increasing both. Thus, higher inflation creates lower P/E values. Since inflation is currently low - indeed some feel the bigger concern at the moment is deflation (see our August 24th post on the inflation vs deflation debate) - and the low expectations for inflation implied by the 2.1% difference per Bank of Canada rates between nominal and real return bonds (see Bank of Canada's Inflation Expectations and Real Return Bonds), we can say that the inflation picture reinforces the idea that current P/E values can be acceptably higher.

Growth Adds to Price and Pushes Up P/E
The final factor to consider is the growth rate G. Using the current earnings yield assumes a steady state with no growth in earnings. It is normal that companies grow, that's what creates economic growth. Intuitively, higher future earnings are worth something to the investor so it is worth paying a higher price today. The more growth, the more future earnings will be generated, so P(rice) is justifiably higher. P is higher compared to today's earnings and so P/E is higher too.

Earnings growth is driven by the combination of the profitability of a company and the proportion of earnings reinvested (instead of being given out as dividends). The higher the profitability and the more that is reinvested, the faster the growth.

NYU professor of Finance Aswath Damodaran has produced a graph that shows how dramatically high the P/E of fast-growth companies can justifiably be. A high P/E stock may reflect a higher potential growth rate and not be a poor value compared to a lower P/E stock with lower growth. Conversely, a low P/E stock may reflect no growth or even expectations of earnings decline and may not be worth buying at all.

Low Interest Rates = Higher P/E and Higher PEG
The net effect of all factors combined shows up in the following table, calculated with standard finance formulas:
  • P/E values are highest for lowest interest rates, no matter what absolute return the investor seeks
  • PEG ratios are also highest for lowest interest rates, where they greatly exceed 1
  • PEG ratios for correctly valued stocks are above 1 in most interest rate scenarios
  • PEG ratios of 1 or less for under-valued stocks only occurs: primarily, when interest rates are quite high (Government bonds at 10% or more) and secondarily, when investors require higher rates of return (5% or more over the Government bond rate)

TSX Over-Valued at P/E 20?
Since the above table shows no P/E above 18 at the lowest possible interest rate and the lowest required return, does that mean the current TSX P/E of 20 indicates an over-valued Canadian stock market?

Not necessarily. If the required Equity Risk Premium lies at 2.0%, below the historical 3.7% TSX rate, the justifiable P/E rises to around 20. Or, if the future profitability (ROE) of companies in the TSX rises fast and is higher than the required investor return by 3%, a P/E of 20 makes sense at current interest rates (see table below).

Bottom Line - Making the judgement of over- vs under-valued is quite difficult because it requires estimating what the future will bring. But we should not trip ourselves up by ignoring current low interest rates that have the effect of raising justifiable levels of both P/E and PEG.

Further reading: Burton Malkiel, author of the investment classic book A Random Walk Down Wall Street, said about the US market in September 2001, Don't Sell Out

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.


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