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.

Company

Share Price

Prospective P/E

Yield

Church & Dwight

$57.68

23.7

1.4%*

Colgate-Palmolive

$107.17

20

2%*

Henkel

47.80 euros

13.3

1.4%*

Procter & Gamble

$65.09

17.1

2.9%*

Reckitt Benckiser (LSE: RB.L  )

3,542 pence

14.4

3.5%

*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.

Company

Share Price

Prospective P/E

Yield

BP (LSE: BP.L  )

438.7 pence

6.9

4.3%

Royal Dutch Shell (LSE: RDSB.L  )

2,218.5 pence

8

4.9%

ExxonMobil

$87.45

11.4

2.2%*

Suncor Energy

$31.70

10.4

1.4%*

*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.

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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.

Company

Share Price

Prospective P/E

Yield

Balfour Beatty (LSE: BBY.L  )

295.8 pence

8.2

4.7%

Carillion

251.2 pence

5.9

6.4%

Morgan Sindall

675 pence

8.8

6.2%

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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.

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Tony owns shares in BHP Billiton, Morgan Sindall Group, Procter & Gamble, Reckitt Benckiser, Suncor Energy, and Unilever, but he doesn't own shares in any of the other companies mentioned in this article. The Motley Fool owns shares of ExxonMobil. Motley Fool newsletter services have recommended buying shares of Procter & Gamble. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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