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Companies
Picking stocks by pegging value - part 1
Trevor Hoey, 28th June 2007
STAY TUNED - Next week CompareShares.com.au will release a list of small cap companies that measure up based on Trevor Hoey’s PEG benchmarking system.
It’s a hot market with plenty of growth or upside factored into share prices, but how do you determine whether the share price accurately reflects the company’s growth prospects? Trevor Hoey investigates
Regardless of how well a stock has, or is expected to perform the age-old question come back to what represents fair value. And what better time to discuss value than now – the S&P/ASX200 has more than doubled from about 3000 points in July 2003 to 6400 points in 2007. That implies strong share price growth, but has there been sufficient earnings growth to justify this rise. Generally speaking the answer is yes, but analysts are noting that the average price to earnings ratio is touching on the long term average.
Whether you are examining analyst’s reports or having a casual conversation, the issue of valuation is arguably the most regularly debated facet of investing. For newcomers to investing, the range of strategies is often confusing, with measures such as price to earnings (P/E), return on equity (ROE), return on assets (ROA) just a few of the more commonly used ratios. Of those, the most simplistic and probably the most commonly used measure is the price to earnings ratio.
The P/E ratio is determined by dividing the company’s share price by its earnings per share. But at that point another issue comes into play. Should the company’s historical earnings be used and if so should the average earnings growth over a number of years be applied in order to factor in the importance of consistent growth?
Where to focus - Posterior or Ulterior
While having a sound track record is of some comfort, a company is only as good as next year’s performance. For example, when a company comes out with a profit downgrade, its record over the last five years doesn’t insulate it from a share price battering.
And what about all the newly listed companies that have flooded the market in the last three years? While some have established businesses and can provide historical financial figures, it is invariably the prospectus forecasts that determine how the company is valued. Furthermore, if we wait for these companies to accumulate a history of financial data, we may miss the opportunity to buy when the price is right.
Bearing these issues in mind and even conceding that when it comes to forecasts companies can miss the mark, it can reasonably be argued that the investor who wants to stay ahead of the game is more likely to base investment decisions on what is unfolding rather than historical data.
The PEG Ratio
Using analyst’s earnings per share forecasts for 2007-08 and 2008-09, average growth for the next two years can be determined. By weighing up the average annual growth against the company’s price earnings ratio relative to 2006/07 earnings forecasts, a benchmark can be ascertained. The following is an example of the formula that is used:
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2007 |
2008 |
2009 |
|
EPS |
10c |
12c |
15c |
|
EPS growth |
n/a |
20% |
25% |
Based on a share price of $2.25 this company is trading on a P/E multiple of 22.5 relative to 2006-07 earnings per share forecasts. Average annual earnings per share growth of 22.5 per cent (20% + 25%)/2 is forecast in 2007-08 and 2008-09.
To establish whether the company’s price earnings multiple reflects a premium or a discount relative to its growth estimates, the P/E ratio (based on 2006-07 forecasts) is divided by the average annual earnings per share growth. In this example, the P/E ratio of 22.5 is divided by 22.5 (average annual earnings growth), benchmarking the company’s price earning to growth (PEG) ratio as 1.
If for example the P/E ratio was 45, the PEG ratio would be 2, indicating that the company was priced at a premium to the benchmark of 1. Conversely, if the P/E ratio was 11.25, the PEG ratio would be .5, indicating that the company was trading at a discount to the benchmark.
This type of data is used by research analysts to assist stockbrokers and fund managers in selecting stocks, but the focus is usually on large cap companies. Given that comprehensive research and a range of forecasts are often not available for smaller companies, this is understandable....but...
Picking smaller stocks using top tier analysis
To broaden investors reach beyond the top tier companies, CompareShares applied the PEG test to identify a clutch of small cap companies that appear to represent good value.
Only assessed companies where forecasts are provided by more than one research house have been assessed, assisting us in gathering accurate consensus forecasts.
Some other criteria such as the size of the company and earnings visibility have been taken into account to assist in providing an interesting range of growth stocks that measure up well using the PEG benchmarking system. The focus will be on companies that have a PEG ratio of less than one, and where earnings per share forecasts reflect growth of more than 20 per cent per annum.
As well as providing the key data, CompareShares will offer a snapshot of each company featured.
Click here to see the second part of this series.
Whatever your views, you can discuss this article - or any of Trevor's articles - on our message board Your 2 Cents.
Trevor Hoey is one of Australia's leading finance journalists, having written for Shares, Personal Investor and BRW magazines. Trevor's broad contact base enables him to find out - and report on - the real story behind what's happening at Australian listed companies. Trevor writes for the Australian Financial Review and AFR Smart Investor magazine.
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