POST OF THE DAY
The BMW Method
P/E Ratio and PEG

 Format for printing Reuse/Reprint

By BuildMWell
January 31, 2006

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

It has been a while since I railed against these factors. I think it is time to do it again. No one has ever accused me of failing to beat a dead horse...I kind of like it.

If we think about what the P/E Ratio means, I think it can easily be shown how silly it is in reality. I hope JoKingMe will allot some time at the BMW Conference to discuss all of this in person. As you all know, I like the E/P percentage much better than the P/E ratio. I understand the percentage yield on my dollar much easier than I can see the merit of buying earnings at a price. This also gives us a ready comparison with bond yields. What will those earnings be in a few years anyway?

If we look at the calculation of the P/E Ratio, we have the Price divided by the Earnings at any point in time. However, what if the earnings grow by 10%? If the P/E Ratio is to remain the same, the price needs to grow by 10% also. This is how many folks try to use earnings growth to justify a stock purchase. Thus, if we have a stock like HAL, the P/E is around 35, but the company stock has grown by just 5% for 30 years. It doesn't take much of a task to make the earnings grow at 5%, so that P/E of 35 can exist forever. But, if the P/E was 5:1. the exact same scenario will make the price grow at 5% forever. The P/E Ratio has nothing to do with any of this...it is just the price divided by the earnings.

HAL's P/E actually was 5:1 in 2002, so let's see. The company has grown at about 5% on average for the last 30 years, so the same 5% earnings growth could easily justify the P/E of 5:1 forever. So, why is the P/E now at 37:1?

In 2002, the earnings were around \$2.12/share. The forward earnings are estimated by some gurus at about \$3.70/share for 2006, but last year they were still around the same level as in 2002 when I started buying the shares. The earnings have gone up and they have gone down...overall, they are about flat. All I can see is the Price went up while the earnings stayed level. Does that make any sense?

The reason for the price change seems to have been in the mood of the market and nothing else. Everyone hears about Halliburton on the news about the war on terror and they know that the Vice President was HAL's past CEO, but that is no reason to buy the shares. The reason to buy the shares is because the earnings are growing. But, they have not grown substantially since 2002.

Now, I thought the price was low in 2002 and I thought the dividend looked nice at 4.5%. The earnings of \$2.12/share could easily pay the dividend, so it was not in jeopardy. Sure enough, the price did rebound, but the earnings never broke out to impressive levels. Even if the company makes \$3.70/share in 2006, the earnings growth cannot justify the stock price growth, which has been over 60% compounded per year. In other words, all I witnessed was a change in price that raised the P/E from 5:1 to 37:1. Meanwhile, the underlying business has grown at 5 to 6% for the last 30 years. To me, this shows the misdirection generated with reliance on the P/E of a given stock. This then makes me really suspicious of the PEG.

I will be the first to applaud the idea of investing in a stock that is growing earnings at a nice clip. That is what we love to find with the BMW Method. But, what price do we pay for that growth? Some experts invented the PEG as a justification for high P/E ratios. They said that the high growth rate was reason enough to pay a high P/E for the shares. But, doesn't this idea automatically make real earnings less necessary? A P/E of 50 says that you really are expecting a 2.0% return on your dollar. And, isn't that exactly what led us into the Internet/High Tech Bubble that destroyed so much wealth from 2000 to 2003? The actual return on those invested dollars was actually negative. The folks who expected 2% got even less.

If we look at a company like Nokia, we find the opposite case from Halliburton. NOK had some earnings problems where the predicted E was to be \$1.10/share and they announced a short fall of a few pennies. The earnings stumbled for a few quarters and then came back. The earnings are again growing at about 20% year over year, but the stock is selling at a P/E ratio of 17. So, we have a business with real, double digit earnings growth that is impressive and the market has chosen to ignore that fact. It is as hard for me to justify that low P/E on NOK as it is the high P/E on HAL. It tells me that people can be manipulated when they are persuaded to look at a stock's P/E Ratio. And, they can be manipulated even more if they buy the concept of the PEG.

If we look at the growth of Halliburton's stock price since 2002, we find a CAGR of 60%. According to the PEG theory, that will justify a very high P/E Ratio. The growth that is being justified is the stock price, not the earnings. People see the nice price curve and do not want to be left behind. So, they justify their purchase based on PEG theory. But, three years is not enough time to see a trend in a business and that is the trap. The trap is that people have a short attention span and they fall for easy explanations. If they are lucky, they get out before the stock price collapses. If not, they take a bath because the price has no real support.

In Jeremy Siegel's book, "Stocks for the Long Run," he discusses this in some detail. He went back to the "Nifty Fifty" of the 1970s and calculated what he termed the "Warranted P/E Ratio" and compared it to the actual P/E Ratio of those 50 stocks. The results were astonishing.

Halliburton happened to be one of the original nifty-fifty. It had a P/E Ratio of 35.5 back in 1972 and the warranted P/E proved to be 10.1. Look familiar?

The best stock of the lot was Philip Morris with Pfizer running a close second. The actual P/E of MO in 1972 was 24 and the warranted P/E was 68.1. Pfizer sported an actual P/E of 28 with a warranted P/E of 79.5. The key to all of this was earnings growth over time. MO's earnings grew at 13.33% over the following 30+ years while PFE's earnings grew at 12.9%. The P/E assigned by the market had no correlation to long term value.

The worst performer of the 50 was Polaroid. They were a hot, hot stock in 1972 with an actual P/E of 94.8. The warranted P/E based on history was 2.3. All that glitters sure ain't gold.

It is the real earnings growth that justifies the P/E ratio, but why confuse things by inverting the numbers. Why not just look at the earnings growth...the E/P over time? And, isn't that reflected in the CAGR of the stock price over time? Plus the dividend gives you a nice return that sweetens to deal. That seems a lot simpler to me. Since the price must logically follow the earnings over time, why not follow the stock price that is sustainable over time and verify that the earnings are sustainable before you buy a stock? That is the underlying basis of the BMW Method. If we find stocks that are irrationally priced too low, we spot them and take advantage of the market's mistake.

I find all of this to be very interesting. Maybe someone here can help me to change my mind. But, until they do, I will tend to ignore the P/E Ratio and use it as a warning signal rather than a reason to buy a stock. I will continue to talk about the P/E Ratio because everyone else does, but I will not put much stock in it. As Jeremy Siegel showed, the P/E has almost no bearing on the real value of an investment over time.

If the P/E Ratio has no real bearing, what the heck can we do with the PEG? It is like putting a tuxedo onto a pig to make it look suave. Some people may actually buy the illusion, but I want to see real growth based on real earnings for my portfolio.

OK, is that horse dead yet?

Become a Complete Fool
Join the best community on the web! Becoming a full member of the Fool Community is easy, takes just a minute, and is very inexpensive.