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Before writing a newsletter on the recent tripling of my old favourite Caledonian Trust, and before writing a report on Connect’s AGM (I’m going down to Swindon on Tuesday), I thought I’d give you some more on share valuation methods. Last week I discussed dividend valuation methods, so that area is covered. In many previous newsletters I’ve explained the owner earnings method by applying it to many of my investments, so today I’ll look at the use of earnings numbers to estimate value.
Price-to-earnings ratio
The most popular approach to valuing a share is to use the price-to-earnings ratio (PER). The historic PER compares a firm’s share price with its latest earnings (profits) per share.
Investors estimate a share’s value as the amount they are willing to pay for each unit of earnings. If a company produced earnings per share of 10p in its latest accounts and investors are prepared to pay 20 times historic earnings for this type of share it will be valued at £2.00.
So, the retailer Next which reported earnings per share of 441p with a share price of £50.28 has a PER of 11.4. PERs of other retailers are shown in the table.
| Debenhams |
7.51 |
| Dunelm |
17.59 |
| Halfords |
12.89 |
| JD Sports |
19.23 |
| Kingfisher |
13.07 |
| Laura Ashley |
11.78 |
| Marks & Spencer |
26.96 |
| Morrison |
15.18 |
| Moss Bros |
12.71 |
| Next |
11.40 |
Investors are willing to buy Next shares at 11.4 times last year’s earnings compared with only 7.51 times last year’s earnings for Debenhams.
One explanation for the difference in PERs is that companies with higher PERs are expected to show faster growth in earnings in the future. Next may appear expensive relative to Debenhams based on historical profit figures but the differential may be justified when forecasts of earnings are made. If a PER is high investors expect profits to rise.
This does not necessarily mean that all companies with high PERs are expected to perform to a high standard, merely that they are expected to do significantly better than in the past. Few people would argue that Marks and Spencer has performed, or will perform, well in comparison with Next over the past two years and yet it stands at a higher historic PER, reflecting the market’s belief that M&S has more growth potential from its low base than Next.
So, using the historic PER can be confusing because a company can have a high PER because it is usually a high-growth company or because it has recently had a reduction of profits from which it is expected soon to recover.
PERs are also influenced by the uncertainty of the future earnings growth. So, perhaps, Morrison and Moss Bros have the same expected growth rate but the growth at Moss Bros is subject to more risk and therefore the market assigns a lower earnings multiple.
PERs over time
There have been great changes over the years ………….
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