Price-Earnings ratios: Not what you think

It must be the ultimate irony that one of the most quoted and used investment tools available, the Price-Earnings (PE) ratio, causes so much confusion among investors who like to treat it as a one size fits all instrument to find "value" in the share market.

But, of course, there is no such thing as a simple universal measure to decide which stocks represent attractive "value" and which ones are "overvalued".

Growth stocks do not trade on a low PE, assuming there is a positive 'P' (profits), unless there is something fundamentally wrong with the business.

Infrastructure assets are valued against bond yields, so whatever calculation is available for a PE plays no role whatsoever.

Then there is your typical commodities producer - highly leveraged to the swings in prices through different stages of the cycle - that turns the whole concept of buying low and selling high on its head.

Every share market veteran knows commodity stocks represent the best value when PEs are sky-high while they are the riskiest when PEs are low (as they are now).

It was only in April this year I was being challenged by investors on Twitter who'd assured me BlueScope Steel (ASX: BSL) shares looked many times over superior to CSL (ASX: CSL) because the respective PEs were 3x versus 40x.

Fast forward five months and BlueScope shares have since lost -32% while CSL shares have actually booked a small net gain. Incidentally, both PEs have now changed to 6x and 33.5x respectively (one year forward).

Needless to say, a lot more context is required to properly read and use PE ratios in the share market.

I can equally confirm the global analyst community has become a lot more sophisticated than when Benjamin Graham wrote The Intelligent Investor and questioned the value of paying attention to Wall Street analysts' research.

For those investors who'd like a great update, and have no fear of being overwhelmed by numbers and calculations and plenty of particularities, The Little Book of Valuation by Professor of Finance at New York University's Leonard N Stern School of Business, Aswath Damodaran offers an excellent modern day curriculum.

Macro PE ratios 

PE ratios are also often used to conduct macro analyses and draw comparisons between sectors and historically distinctive periods. Again: this can be very useful for the average investor if the proper context is included.

A recent historical analysis of macro PE ratios by analysts at JP Morgan offers plenty of insights that could prove useful in the year(s) ahead, starting with the identification of four distinct periods throughout the past thirty years.

The 1990s, JP Morgan research has unveiled, was a period of rising corporate earnings and expanding PE multiples.

Such a combination is quite rare in Wall Street history. Forward-looking markets tend to moderate PE multiples when the growth outlook is strong and lift them when the outlook weakens, but in particular, towards the end of that decade investors threw all inhibitions overboard, and then paid the price for it throughout the 2000s - that era started with a gigantic de-rating of valuations that lasted until 2005.

This was equally the period when energy producers and mining companies made a firm comeback as the world's attention shifted towards the emergence of China as a new economic superpower.

Super-prices for commodities led to the idea of a Commodities Super-Cycle, with companies like BHP Group (ASX: BHP) and Rio Tinto (ASX: RIO) enjoying super-profits, but it never led to oversized PE ratios, despite the general excitement that built up over those years.

Note how the de-rating of prior high-flyers fell in line with a prolonged Super-Cycle period for commodity stocks that commanded generally lower PE ratios, with the combination of the two facilitating positive share market returns but at much lower PE multiples.

That era came to an end with the GFC bear market, with the subsequent decade-plus characterised by the Great Yield Compression, which once again opened up a new era in which average PE ratios would move substantially higher.

On JP Morgan's analysis, US equities commenced the new era on a general PE of 14.7x and by the time covid hit in 2020 that number had risen to 27x for a remarkable expansion in market multiple of 12.3pts. It's probably fair to assume such expansion had never been witnessed before.

But similar to the previous pre-2000 period of multiple expansion, this latest one came to an end with the global pandemic, even though PE multiples rose substantially in 2020 as forward-looking investors anticipated the post-covid recovery.

As corporate profits bounced, broad-market PE multiples declined at first, but subsequently increased again and stayed high until bond market yields rose substantially early in 2022.

That moment, we know now, ushered in today's new era of much lower PE multiples. JP Morgan research shows the PE compression for the S&P500 to date has been a super-sized -8.9pts.

And just like what happened between 2004-2008, energy and mining companies have taken the lead in share markets to date, often combining super-low PEs with super-sized profits, cash flows and dividends.

The multiple for the Aussie market (and its darlings)

Contrary to most US-centric analysis, JP Morgan has done the numbers for Australia too.

First observation: the multiple for the ASX200 hasn't moved much (net) since 2012 with the PE at both ends around the long-term average of 14.5x, pre-September selling.

The index has appreciated by circa 50% over this period, which is equal to the growth in the local market's average EPS over those years! The adage that, ultimately, investing in the share market relies on corporate profits certainly rings true (ignoring everything that happened in between).

Over the past ten years, reports JP Morgan, only two years have witnessed earnings and multiples moving in concert for the ASX: 2013 and 2016. The local Small Cap Index experienced one rare year in which multiples and earnings descended in tandem; it happened in 2014.

According to JP Morgan, this was largely a function of the small-cap resources drag. Small cap resources experienced a strong recovery through 2015-16 with both earnings and multiples rising. This year, however, small-cap stocks have suffered most as investors see them as more vulnerable in the face of economically more challenging times ahead.

Technology, mining and discretionary in particular have become the obvious victims.

JP Morgan has put the old adage to buy resources when multiples are high and sell them when they're low to a historical test, and the mantra has mostly proved correct, say the analysts.

By December 2015, the average PE for the local mining sector had risen beyond 20x, marking a decade high.

As long-term price charts indicate, this also marked the low point for most share prices. Shares in BHP, for example, temporarily sank below $14. The ASX chart for Fortescue Metals (ASX: FMG) shows a price below $2, while Santos (ASX: STO) witnessed a price of $3.

The energy sector, while dominating returns throughout 2022, experienced another fall-of-the-cliff experience when covid hit in 2020. The latter, by the way, also included the coal sector.

JP Morgan observes how the preceding year, 2019, was one of few when both earnings and multiples for mining companies rose as market forecasts for bulk commodities improved.

Fast forward to 2022: the local mining sector is currently trading at a decade-low PE of 9.3x. On JP Morgan calculations, a reversion of the sector multiple to its long-term average of 13.5x implies an earnings downgrade of circa -30%.

History shows the same basic principle equally rules when investing in oil and gas producers, conclude the analysts, albeit with the added observation that multiples and profits for the likes of Woodside, Santos etc never move in the same direction, and any adjustments are the most volatile of all sectors.

On current forecasts of 20% EPS growth for the sector in FY23, JP Morgan estimates the sector PE will shrink to circa 5x assuming no further price appreciation.

Local bank ratios 

JP Morgan has equally a rather subdued message for investors in the local banks; while profits are expected to rise over the next twelve months, the analysts believe the sector PE multiple is poised to de-rate in the face of economic challenges ahead, which implies limited upside potential only.

Australian banks have had a difficult decade, point out the analysts, only achieving negligible net EPS growth over the past ten years. Over that period, Return on Equity (ROE) for the sector has halved, capital ratios increased and margins declined as competition intensified (see also: Macquarie Group in mortgages) and the Royal Commission lifted overall costs.

No coincidence then perhaps, most share prices in the sector today are at a similar price level as back in 2012, or lower, with exception of National Australia Bank (ASX: NAB) and the one superior performer locally, CommBank ( ASX: CBA).

I never get tired of pointing out to investors: there is only one local bank whose share price is trading higher today than pre-GFC in 2007, and that is CommBank.

All other share prices are significantly lower still, and, in some cases, only briefly managed to revisit pre-GFC levels helped by falling bond yields in 2015.

Similarities between growth stocks and retailers' ratios 

Two important observations further stand out: the PE for your typical growth company tends to lift with rising profits, and fall as analysts downgrade forecasts. This easily explains the attraction of such companies during the good times and why the punishments are so harsh when the outlook changes.

A similar pattern, apparently, characterises the local retailers. The past decade reveals a close relationship between the direction of household goods retail sales, earnings for retailers and the sector multiple. On JP Morgan's observation, all three moved in the same direction in 2016 and 2020.

Alas, for the year ahead, JP Morgan's forecast is for a general decline in retail goods sales which is not that different from the general anticipation of higher interest rates ultimately hitting Australian consumers' ability to spend on discretionary items.

Healthcare PE ratios 

The final sector observation in the report highlights the danger of working with broad averages - there is always room for opposing details beyond the average and investors would be wise, in broad terms, not to neglect individual company specifics.

The sharp outperformance of CommBank throughout a decade of no net gains for Australian banks is one such prime example.

The local healthcare sector, reports JP Morgan, has enjoyed a long period of expansion in both earnings and multiples through to 2020. But now the broker's forecast is for a largely unchanged sector EPS in FY23.

Hence any upside will have to stem from multiple expansion, which is still possible, of course, as reliable and defensive healthcare earnings and dividends become more attractive in the face of rising uncertainties about next year's outlook for the global economy.

However, what this generalisation omits is the ASX healthcare sector combines both covid-victims and beneficiaries, meaning the finer details behind that average offer a lot more nuance (and potential upside).

Plasma and vaccines company CSL, for example, is currently forecast to grow EPS by double-digit percentages in both FY23 and FY24. If correct, this will pull back its PE multiple to 27x by mid-2024.

The numbers do not look fundamentally different for sleep apnoea market leader ResMed whose PE is equally projected to shrink to 27x over the next two years.

For hearing implant company Cochlear (ASX: COH) the estimated pace of growth looks decisively lighter and the projected PE numbers significantly higher.

Then there's Sonic Healthcare (ASX: SHL) for which the coming years, as a former major COVID beneficiary, look a lot more challenging. Current forecasts are for two years of steep declines in profits, poised to effectively double the stock's FY22 PE to 20x by 2024.

A final note

As such, investors are yet again being reminded: PE ratios can be a very useful tool, but only when combined with the right context and background.

Heavy selling in September has pulled the forward-looking PE for the Australian share market to 13.23x, according to Morgan Stanley, suggesting deep value is now on offer, given the market's long-term average is circa 14.5x. Last year, the PE almost touched 20x while at the start of 2022 it was still at 17.7x.

However, investors would probably also like to know the multiple for local Industrials ex-Financials sits at 22.6x (still above the long-term average).

Financials are trading broadly in line with their long-term average PE of 13.5x. At 8.1x, Resources have only traded at a lower PE once since 2003; back in 2008.

Then there's still that same key question: how heavy will the downgrades be in 2023? Or should the focus be instead on which companies are not at risk of cutting their dividend or disappointing operationally?

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