Wednesday, January 17, 2007

Quick Lesson: P/E Ratio vs EPS Growth

Yesterday I recieved an E-Mail from a reader, asking me to review a particular company, whose P/E Ration is extremely low, but growth is almost not consistant.

I'm aware that most professional research companies use P/E Ratios to pick out undervalued stocks. I find it amazing how these reports put so much emphasis on P/E ratio, cause I find a consistantly growing EPS more important than a low P/E ratio.

"EPS growth is more important than P/E Ratio. I say that through experience and research."

The idea of comparing 2 competitor's P/E to decide which stock is undevalued is wrong. Lets take stock A and B. Stock A has a P/E ratio of 5x while B has 30x. Stock A has reported flat annual earnings, while B reported growing profits of 30% annually (and of course 30% EPS growth).

Before you buy Stock A, you should ask yourself this question. "Why is there such a big difference in P/E ratio?". Well, P/E ratios are really affected by market anticipation of a company's potential. There really isn't any anticipation for a good future for Stock A, due to the company being unable to grow earnings. There is no reason to expect increase in earnings.

However, Stock B has been growing. In theory, a 30% profit growth should translate to a 30% increase in share prices, all things being equal. Most investors will invest in this company as they anticipate higher earnings.

"Which stock will you invest your hard earned money?

How many of you thought that singtel was expensive at $3.00 now $3.40, and shyed away from investing in it. Capitaland when it was $5.00 now $6.00 SGX when it was $5.00 now $6.00. High P/E ratios. don't invest. Google was $400, now $500. Well you missed more than 20-30% of profits. These companies have a few things in common. High P/E rations, and more than 20% EPS growth.

"Anticipation for profit growth (EPS growth) is an important market force, able to push P/E ratios up. But a high P/E doesn't make a stock unattractive"

Given the rare chances of a low P/E ratio stock surging thru a 1 day frenzy, you're better off putting your hard earned money in a company that can almost guarantee growth thru their operations, using the above companies as prove of the importance of EPS growth.

"Investing in a low P/E company with no EPS growth is like gambling."

Next time when you recieve a research report, claiming stock growth due to low P/E, maybe you should look between the lines, in the financial statement. Look for EPS growth, not the P/E ratio. Or you should just check if those research companies have vested interested in low P/E companies. Maybe thats the reason why they upgraded that company.

The real ideal investment would be in a company with low P/E ratio, and high EPS growth. These stocks are putting in great profit growths, but have not been discovered. But chances are, you will never see this.

33 comments:

termsandconditions said...

thank you for the enlightening post ;)

sbh said...

Hi, can you help to analyse for OSIM share plse? Tks.

Anonymous said...

Hi,

I think your blog is great but I do not agree on the part about P/E vs EPS Growth.

EPS Growth is definitely the way to determine if a company is worth investing or growing. But it does not present a snapshot or take into consideration current price.

Sure, a company may have 20% EPS growth but if the current price already factored in the future potential, then price will not be rising much. Therefore, I feel P/E still provides generally good indicator of current valuation.

However, I agree to have a full picture, one should be looking at both EPS growth as well as P/E. And definitely margins, in my opinion. Few basics to look into after looking at the absolute numbers such as revenue and profit.

PeHon said...

Well, regarding the market factoring the future potential, you've got to agree with me that the market is short sighted. the most they lookforward to is 3 months. SO if every quarter the market factors in the potential, than no problem in price rise.

On top of that, if EPS is >30% quarterly, the truth is the price will always be playing catch up.

Just my opinion, and experience

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