Business Maverick

Business Maverick

After the Bell: The ratios and proportions of optimism and pessimism

After the Bell: The ratios and proportions of optimism and pessimism

Maths jokes are hard but there are a few goodies. Do you know why men go to Woolies to try and meet women? Because the ratio of women to men is 10 to 1 and they are already looking for stuff they don’t really need.

Ratios, in general, are hard too. But there is one ratio that is interesting at the moment, particularly for investors, and that’s the price-to-earnings (P/E) ratio. For the uninitiated to this little confounding complexity, it is perhaps the most popular comparable measure of a company’s value out there. It is calculated by dividing a company’s market price by its earnings per share.

What you get is a wonderfully profound, comparable, easy-to-use, and potentially extremely misleading ratio. Generally, the number will range somewhere between 10 and 30; a low number will suggest a company is cheap because its market value in relation to its earnings is low, and a high number suggests the company is expensive for the opposite reason.

But, of course, it’s complicated because a fast-growing company might have a very high P/E today, but if it’s growing fast then as its earnings rise, the ratio will decline. So a high P/E is not necessarily a reason to avoid a share; it could be exactly the reason to buy the share! Life.

And the opposite may be true. If a company’s P/E is low, that might generally suggest it is cheap and it could be a good idea to buy the share. But in my experience of the stock market, quite often dogs will be dogs, and the shares just never recover. And they sometimes get worse.

There are other oddities: companies that are loss-making have infinite P/E ratios, so in this case the ratio is useless – like the company it applies to, some would argue. Quite often, the P/E ratio of a company’s past earnings will differ massively from its predicted future earnings, so there is this whole class of “forward P/Es” that aim at more accuracy at the expense of certainty. And of course, because this is earnings we are talking about, accounting rules can make a big difference.

The battle of ratios, as they say, is one of epic proportions. (That’s an old maths joke, by the way, which says more about mathematicians than it does about humour).

Anyway, in general, I think P/E ratios work best with large, established companies with more or less predictable earnings. And that means one of the most useful aspects of P/E ratios is what they tell us about the most important groups of companies, gathered together in an index. This is because the aggregation process helps smooth out some of the anomalies.

The reason I’m raising all of this is because of a recent column in the Daily Maverick by economist Roelof Botha, who pointed out just how fabulously cheap the SA market is at the moment. He compared the handful of successful tech stocks in the US pushing up the market there to the old-fashioned resource and manufacturing companies in South Africa.

The difference is startling.  The weighted average P/E of Nvidia, Broadcom, AMD, Intel, and Adobe is 177. The weighted average P/E of Sasol, Kumba, Sibanye, Exxaro, and ARM is 6.1. For Botha, this is a great illustration of just how cheap SA shares are at the moment.

You can extend this analysis a bit too. The average P/E ratio of the companies on the S&P 500 is currently just below 25. That is pretty pricey by historical standards, and certainly surprisingly high for a high-interest rate, low-growth environment.

The average P/E for the top 40 companies on the JSE is currently just above nine. That is almost unheard of historically. Normally it’s around 15. Just to take an extreme example, coal miner Thungela Resources is currently sitting on a P/E ratio of 1.3.

I don’t think I have ever seen that in a company with strong earnings worth over R20-billion. It has a dividend yield of 62%; normally dividend yields are 5% if you are lucky. Okay, earnings are likely to decline over the next year, so the ratio will probably increase. Thungela’s forward P/E is around 3.4. But still, that does shout “buy” at you.

But, of course, there is that caveat mentioned above: sometimes P/E ratios are low because they should be low, not because they are irrationally low. Whatever the case, the low P/E ratios of SA’s biggest companies reflect the doubts over the future earnings of the country’s businesses and indeed the country’s future. In the best of circumstances, you would expect a revision to the mean. But there is always the “dogs will stay dogs” scenario to chew on, too.

Good investing,

Tim Cohen


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