Why a P/E of 17 Isn't Necessarily Expensive

LONDON -- Last Thursday the Anglo-Dutch consumer goods multinational Unilever (LSE: ULVR.L) released its results for the first half of 2012. The market liked the 6% jump in earnings per share, and its shares rose by 5% on the day. They now stand at 2,260 pence, where the consensus forecast EPS for the full year of about 130 pence puts them on a price-to-earnings ratio of 17.4, and they yield 3.4%.

Many investors avoid Unilever because its P/E ratio is much higher than that of many companies in the FTSE 100 index. I'd argue that the better comparison is with Unilever's peer group, the other consumer goods multinationals, especially since the index is distorted by large oil and mining companies like BHP Billiton, whose shares are on low P/E ratios.

When you look at the competition, Unilever doesn't stand out as being particularly expensive.

The rest of the sector
Below is a table showing the figures for five other consumer goods multinationals.

*After deducting 15% withholding tax to get a net yield (i.e., what British companies pay out).

Shares in consumer goods companies invariably trade at high P/E ratios, especially in troubled times, because they are "defensive" businesses. This means that their earnings remain fairly stable during a downturn, as most people are reluctant to cut back on their products. When a recession hits, it's easy to decide not to buy a new car, but few of us will skimp on laundry detergent.

Henkel's shares trade at a lower P/E ratio because it has a substantial adhesives business, whose earnings are a bit less predictable, and it is more exposed to the eurozone.

Furthermore, rising consumer incomes in the emerging-market nations mean that these companies can tap into a new source of growth, and investors are prepared to pay a premium for this.

Black gold, low P/E
The table below summarizes the key figures for four of the world's biggest oil companies, and as you can see, the British and North American majors trade on similar P/E ratios.

*After deducting withholding tax at 15%.

The oil majors haven't been good performers in the last few years because of the global recession and market expectations that future competition from shale gas will depress the oil price, so their P/E ratios are much lower than the consumer goods companies. BP has one of the lowest P/E ratios in the sector because of its role in the Deepwater Horizon disaster of 2010.

Oil is my favorite sector of the stock market, where I invest in both the majors and small high-risk explorers where fortunes can be made (and lost) with a single drilling result. If you're looking for riches from the oil and gas industry, the new Motley Fool report "How To Unearth Great Oil & Gas Shares" might be just what you want. It's free, so click here for your personal copy.

Low P/E, high yield, higher risk
The construction industry suffers quite badly during an economic downturn because people tend to put off new projects and stop buying new houses. The result is that builders and building suppliers have poorer-quality earnings, so their shares trade at fairly low P/E ratios.

The table below shows three of the larger British builders, and as with the consumer goods and oil companies, their ratings are broadly similar.

I favor a sector-based approach to investing, where you first consider the industry before looking at individual companies. Sometimes the decision to avoid a particular sector can be just as important as choosing the sectors in which to invest. If you're looking for some sector-based ideas, you might like to take a look at the Motley Fool's "Top Sectors for 2012," our latest guide to help investors. Click here for your free copy.

Compare with gilts
It's always a good idea to compare the income paid by shares with the returns which are available on medium- and long-dated gilts -- fixed-interest bonds issued by the British government. Gilts, deposit accounts, and direct property investment are the three main alternatives to shares, so you should always have a rough idea of what these assets are currently paying.

15-year gilts currently yield 2.2%, while 30-year gilts pay 2.9% -- respectively equivalent to P/E ratios of 45.5 and 34.5. These figures are gross redemption yields, or the return you will earn by holding them until maturity. This allows for the guaranteed loss of capital, as these gilts are currently trading at a premium to their redemption price.

I'd much rather put my money in all of the consumer goods companies mentioned earlier than in 30-year gilts. Their average dividend yield is just more than 2.4%, while their average P/E ratio of 17.7 represents an earnings yield of 5.6%. Growth will likely ensure that both of these yields, based upon today's prices, will be much higher in 15 and 30 years' time, when 30-year gilts will still be paying 2.9% to today's buyers.

If you're new to the stock market you might like to take a look at this special report -- "What Every New Investor Needs To Know." Click here for your free copy.

Further Motley Fool investment opportunities:

• The One UK Share That Warren Buffett Loves
• 10 Steps To Making A Million In The Market
• 8 Shares Held By Britain's Super Investor