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Does price earnings ratio matter?

June 26, 2007
William Spetrino Jr

William Spetrino Jr

0 followers

In the past 10 days I have spoken with 3 friends of mine who all invest in the stock market. These 3 people do not know each other but all 3 of them are predicting bad times for the stock market since the bull market has lasted 5 years. They have complained about how Coke, General Electric, Johnson and Johnson, IBM, Merck and Pfizer have performed poorly for them. (Each of the 3 at least owned one of these stocks) Of course when it mentioned to them that I have recently taken a large position in Johnson and Johnson, all 3 of them "warned me" that the stock has performed poorly in the past 8 years and many included Jim Cramer and themselves told me it was "dead money" (FYI this is a bullish response for me). When I mentioned to them that JNJ has an Return on Equity of 25% and a PE near 15, all 3 had the same response "SO WHAT" and proceeded to tell me that while I have had success in the past that this time I had miscalculated and one went as far to say that my reliance on low PE stocks was "outdated". Hence another "Billytickets” experiment was born.

Of course as was stated in the forum yesterday a Low PE stock is not necessarily better than a high PE stock with a high ROE which I agree with. But what about 2 stocks BOTH with High ROE's?  My exercise was to take an identified member of stocks (Dow Jones top 30) and check how many stocks had an ROE of at least 25% the previous year (or 5 year average) and had higher earnings than capital expenditures, and then examine them when 1) Their PE was 15 or lower based on previous years ACTUAL earnings not "projected earnings”. 2) The same stocks when the PE was 30 or higher. My "universe" of stocks was whittled down to 11. They consisted of MMM, MO, AXP, CAT, KO, GE, IBM, JNJ, MRK, PFE, PG. 4 stocks were purchased by BOTH number 1 and number 2. Each stock was purchased from the 10 year period from 1996 to 2006. 

The Dow stocks with PE of 15 or less and a ROE of at least 25% had 28 purchases over that span that cost $1222.10 and were held for an average holding period of 5.39 years. As of Friday's close the portfolio totaled $2,085.82 for a gain of 70.67% .This translates into almost 12% annual return compounded in portfolio gain ONLY. The present dividend from this portfolio is $59.95 which translates to about 4.9% yield on purchase price. This does not take into consideration the "reinvested dividends" which is certainly material and will add to the overall return. Ironically in 2000 the year the market "topped out" only 1 purchase (3.57% of total purchases) was made and that investment has doubled.

The Dow stocks with a PE of 30 or more and a ROE of at least 25% had 39 purchases over that span that cost $1784.30 and were held for an average holding period of 7.410 years. As of Friday's close the portfolio totaled $1996.01 for a gain of 11.86%. This translates into slightly more than 1.5% annual return compounded. The present dividend from this portfolio is $53.04 which translates into a 2.97% yield on purchase price. In 2000 the year the market "topped out" 8 stocks were purchased (20.55) and 4 of the 8 are still lower 7 years later and none achieved double digit annual compounded returns.  8 of the highest ROE Dow stocks with PE's over 30 seems to be an indicator that the market was "overvalued” it would seem.  2 factors even make this scenario worse for the High 30+ PE stocks. 1) As stated above the reinvested dividends were more than 65% higher on the low PE portfolio which makes the differences in return even more drastic. 2) On more than 40% of the High PE purchases the PE was over 30 for the entire year and I used the LOW for the year as my "entry price". Doing this favors the high PE purchases but a material and significant margin. Despite this "advantage" the portfolio still performed horribly.

Buying the right stock at the right price is PARAMOUNT to achieving above average returns in the market. My friends purchase of GE, JNJ, PFE, and MRK was not the problem. All 4 companies have achieved favorable results. Their entry point during a PE of 30 or more caused their poor returns not the CEO's.  2 other stocks Home Depot and Wal-Mart did not meet the 25% ROE or the results would have been even WORSE for the high PE’s. In the final analysis "value investors" need to 1) Buy the right stock (a stock with a ROE of 25% or more is "preferred" . 2) Buying that stock at the lowest possible PE ratio will give you the "margin of safety " needed to achieve success in investing. So when someone tells you that the stock is a buy at ANY price, hopefully the "results" in this article will bring you back into "reality".  As a side note NONE of the Dow 30 stocks with the highest ROE's have a PE of 30 or more which it makes the probability of a stock market "crash" like we had in 2000-2002 to be minimal. Please give me your feedback, positive or negative.

The actual purchases are available if you want them faxed to you, please contact me. 

About the author:

William Spetrino Jr
GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.8/5 (16 votes)

Comments

musto
Musto - 7 years ago


Excellent research.

"Got nothing to add".


kfh227
Kfh227 premium member - 7 years ago
Awesome study! Can't say it had shocking results.

What you said about your friends reminded me of the "Average gurufocus reader vs the rest of the amateur investing world" thread.
billytickets
Billytickets - 7 years ago
Yes at gurufocus we are a "special" group of value oriented guys. Many "gurus" have tried to tell the world that price earnings ratios do not have to below for an investment to be agood one. Buffetter17 mentioned Ken Fisher saying a company witha small PE ratio is not necessarily abetter stock than one with a high one. I agree totally but when you have 2 stocks BOTH with high ROE's the one with low PE should be chosen. My data has shown that. As i have stated earlier buying "small caps" is not my "universe" and is in the "too hard" pile for me .( i believe others can do it but not me) Investing in a small cap with a high PE can be very profitble ( Krispy Kreme comes to mind) .But buying a stock with a 40PE because you have forecasted a growth rate of 75% for the next 5 years MAY work but it is not"value investing" in the Buffett or Schloss or Graham mode IMO. When I bought my Altria in 2000 at 7 times earnings and a dividend yield of 10.5% with a stock who dominated the US market in food and tobacco and was 2nd in beer many "investors" told me that Kraft was probably worth as much as I paid for ALL of Altria( therefore the ENTIRE tobacco,International and domestic along with MIller beer to be FREE) The margain of safety was much"different" than buying any stock in the world with a PE of 30 or more .( even the ones that became profitable in the future) because Altria earnings were "predictible where the small cap had no such track record or past dominance in their market. All the discussion I have at th is forum are educational in one way or another ,especially one where someone "disagrees" which make you "check your hypothesis" for "holes".I have grown to love musto's mental sparring especially

Anyhow 3 people have already emailed me and told me that since they read my article that Johnson and Johnson has become more"appealing to them at 14-15 times earnings. I have made no secret that iam long JNJ .Glad you enjoyed the results kfh227
billytickets
Billytickets - 7 years ago
KFH227 How imporatnt is ROE in your calculation?
kfh227
Kfh227 premium member - 7 years ago
billytickets Wrote:

-------------------------------------------------------

> KFH227 How important is ROE in your calculation?


I don't use ROE directly when calculating hat I view fair value to be. Lately, I am keeping an eye on it. I always filtered stocks using Value Lines "financial strength" rating. Now that I am keeping an eye on ROE lately, I am starting to notice a correlation between financial strength and higher ROEs. After looking over some of the specifics of USB today, and starting to wonder why it's liked so much by WEB, I noticed the ROE and it hit me in the face like a pile of bricks.

I use ROE more as a verification of quality than anything else.

So, to answer your question, when calculating fair value, I don't use ROE directly. But I am trying to pay attention to it these days.
billytickets
Billytickets - 7 years ago
ROE is personally a "filter" for me ( i have to have full understanding and appreciation for the business). Do you project what earnings will look like?And if you do how far do you go out? This question is not just for kfh227 only?
musto
Musto - 7 years ago
ROE is the single most important indicator of business moat.

If you look at it from a business owner's point of view, you'd

appreciate this metric very much.

armeetofo
Armeetofo - 7 years ago
ROE is my most important filter, one step further, i look at the trend should be even or up for last 10yrs, i feel a lot more comfortable in that company.
billytickets
Billytickets - 7 years ago
Interesting discussion>ironically when i started investing I did not consciously do it but was attracted to those companies with a high ROE. PFE MRK and JNJ are all low PE and high ROE stocks that have been"neglected" by the "raging bull".Any comments from our knowledgable panel here?
harison
Harison - 7 years ago
I think ROE is a good number but is one factor. Theoretically any company could lever the balance sheet way up and buy back stock. This would aritificially inflate the ROE, hence consumer staples carry lots of debt and generally have big ROE's. I think if you have a company with idustry leading margins and a big ROE, in all likelihood you have a nice moat. Combine these two factors with an attractive price and you've probably got a nice investment opportunity. My pontificating is done for the day, and their are twelve Coronas with my name on them. Happy 4th everybody!
armeetofo
Armeetofo - 7 years ago
i agree what you said

personally i don't like stock- buy- back company, just like i have a lot of cash with nothing to do, that is sad, i feel boring and want to do something to pleased to shareholder or wall street, i manipulate the numbers, it is danger to me.

happy 4th day, everyone, enjoy investing!
kfh227
Kfh227 premium member - 7 years ago
Read up on what Buffett thinks about them, you might change your mind.

armeetofo Wrote:

-------------------------------------------------------

> i agree what you said

> personally i don't like stock- buy- back company,

> just like i have a lot of cash with nothing to do,

> that is sad, i feel boring and want to do

> something to pleased to shareholder or wall

> street, i manipulate the numbers, it is danger to

> me.

> happy 4th day, everyone, enjoy investing!


recortes
Recortes - 7 years ago
Hi,

I think the article is just another way to put the Magic Formula by Greenblat's. High ROIC/ROE/Margin, low price.

Regards.
armeetofo
Armeetofo - 7 years ago
kfh227:

i don't understand what you mean, what should i read up warren's thinks, what kind of mind should i change?

the post i talk about is not for warren, i am brk-b shareholder.

feel free to answer me thanks
kfh227
Kfh227 premium member - 7 years ago
stock buy backs are something Warren is in favor of. That's all I am really saying. If you think about buy backs, they are a good use of capital. The example that comes to mind is when Warren convinced the Washington Post (long time ago) to start doing buy backs with it's excess cash. Buying other papers at the time at a premium made no sense. The way to improve share holder value is often via buy backs. On a per share basis, everything improves. EPS is up. Sales/share, everything.
armeetofo
Armeetofo - 7 years ago
thanks a lot, i agree with what you said.

in my viewpoint, if i have cash in hand, the positive action is to expand my busineess, when i don't have any object to do, then the negative action is to buy back stocks. only at this point, nothing else. thanks again for your answer.
billytickets
Billytickets - 7 years ago
I think smart CEO's should buy UNDERValued companies with extra money,especially there own. Look if Pabrai puts 12% of his portfolio into berkshire and Buffett puts 3 billion into JNJ.CEO"s JOB is to ALLOCATE CAPITAL at HIGHEST rates for lowest risk. Anyone who can not see BRK and JNJ are"bargains" should NOT IMO be a CEO. Anyone one else have an opinion on this?
billytickets
Billytickets - 7 years ago
would you ever buy ahigh PE company without alot of Cash or hidden assets ?What is the highest annaual return you forecast forgrowth ona 3 year basis.In 1996-2000 Microsoft eranings went up 300% in 4 years The last 7 only 80% ( which is darn good).peace
kfh227
Kfh227 premium member - 7 years ago
billytickets Wrote:

-------------------------------------------------------

> would you ever buy ahigh PE company without alot

> of Cash or hidden assets ?What is the highest

> annaual return you forecast forgrowth ona 3 year

> basis.In 1996-2000 Microsoft eranings went up 300%

> in 4 years The last 7 only 80% ( which is darn

> good).peace

I do this all the time with companies with little or no debt.

LLTC has $6 per share and no debt and traded at around $30. $30 would be fine for a stock with normal debt levels. I tacked on $6 to get intrinsic value. Go figure, they announce a HUGE stock buy back (by adding debt and using cash on hand) and plan to carry more "traditional" debt loads. Stock jumps $6 the next day. Odd? I think not.

And yes, LLTC did carry a higher PE. Still does actually, but once ~25% of the float is gone, that will correct.


billytickets
Billytickets - 7 years ago
what was lltc pe ratio?just curious
kfh227
Kfh227 premium member - 7 years ago
billytickets Wrote:

-------------------------------------------------------

> what was lltc pe ratio?just curious


The buy back just started in LLTC. So, the numbers still are accurate on Yahoo.

The current PE of 27 should be accurate. Once the buy back is done, the PE will be more along the lines of 20 at current quote. Now what WAS the PE? Well, the stock was at around $30 and the PE in the 21 neighborhood I think.

All that cash and no debt does represent value. Untapped value. The thing is, most people just figure it is going to sit around and collect a 5% yield. Which his true. But to me it represents untapped potential. Once untapped, shareholders are rewarded.

You can see the jump about 3 months ago:

http://finance.yahoo.com/charts#chart2:symbol=lltc;range=6m;indicator=volume;charttype=line;crosshair=on;logscale=on;source=undefined

That was the buyback announcement and change to more traditional debt loads.

LLTC is far from a value play, but I am still coming to terms with the idea of selling stocks I hold.

LLTC isn't hte only company maintaining cash hordes that could do this. Others have recently done hte same thing and alot of other companies are trading at premiums as though they are expected to follow suit.
billytickets
Billytickets - 7 years ago
thnaks for the info
billytickets
Billytickets - 6 years ago
Just curious to the magic formula guys How many stocks with a ROC of 20% or more and a ROC of 26% ( according to value line) over the past 3 years and a PE of 16 or less on last years earnings are there at this moment?I would be curious to track these companies and see if they "outperform" the other magic formula prices.Anyone UP TO THIS TASK?
billytickets
Billytickets - 6 years ago
With all this "doom and gloom" casting its spell over the market keep something in mind while others around you are panicking. The high flier PE's who moved the"fastest" in the upswing "generally" fall the fastest when the market "corrects" as it must. Stocks like BRK BUD MO KFT WMT of course JNJ and others have "underperformed" all year and if you own these stocks your earnings are not going to be affected by all this"doom and gloom". Mr Market is here toSERVE YOU not guide you.
billytickets
Billytickets - 6 years ago
Mr Market changes his moods drastically yesterday. Please share your stories about any"bargians" he has handed you in the last week.
ccyork
Ccyork - 6 years ago


billy

i've got my eye on several stocks, but with only a limited amount of cash, i feel a little paralyzed right now because i want to get the best deal and my favorites keep dropping every day

no sense in spending my money on a "great deal" when an "awesomely incredible deal" could come my way tomorrow. i know it doesn't make sense...and yet it does

i like watching the prices drop, but this is a little frustrating

-- ccyork

armeetofo
Armeetofo - 6 years ago
billy:

what are your bargains?

any good comments?
billytickets
Billytickets - 6 years ago
Right now as you know i addred to my JNJ last week lowering my overall basis to 61.03.

MO got as low as 63 on Monday ,that looked appetizing but I have as much MO as I want

.KFT is lower than what Peltz Icahn and WEB paid but again I have a lot of it.

USG was very tempting under 42 . personally i am waiting for the "banks" to drop further and when the market gets to apoint where i feel the pain is starting to"level off" i will let everyone know.USB is a great stock if you are ready to average down.What do you think is cheap now armeetofo and OTHERS?
kfh227
Kfh227 premium member - 6 years ago
billy,

Keep an eye on PFE. I want a drop of $1 more, but I am eyeing it. I would do naked puts if it did drop another $1. Big safe dividend, buth the risk is slow growth. The overall return is attractive. And PFE only needs to find 1 or 2 blockbusters and the stock could shoot to $100. That's specualtive. From a value standpoint, I think it is great. And it has the potential to go much higher rapidly.

As for hte threads topic. I jsut read an interesting article that says PE is important to value investors. But ROE is much more important. I'm starting to agree on this, but I still see PE as a primary indicator for high quality, well established stocks. That's all I buy so I still use it.
kfh227
Kfh227 premium member - 6 years ago
Oh, also keep an eye on GE. It has the same appeal to me as JNJ does. I wnat it for $35 though, not $38-$39. I will pounce on a dip.
ccyork
Ccyork - 6 years ago


i know it's not most people's cup of tea, but DFS (Discover Financial) is really cheap

and it could very well get a lot cheaper before its all over, the way things are going!

-- ccyork

billytickets
Billytickets - 6 years ago
Kfh22: i like GE but if it was "really cheap" like JNj WEB would have been buying IMO.


This article PROVES that ROE is NOT more important than PE. The study which is the"basis" of the article proves that in a given Universe" ( the dow 30) Companies with High ROE and LOW PES OUTPERFORM SIGNIFICANTLY HIGH ROE AND HIGH PE companies. Send the author of that article my"link" so he can see the"facts".lol .

I will have a new article out any day now about dividend yield as well. Dividend yield PE ROE ROC and averaging down are all VALUABLE concepts which have stood the test of time.Do you agree? Anyone want to comment?peace

armeetofo
Armeetofo - 6 years ago
billy:

i am with you again today, i did JNJ a dime more than you did,

you are always better than me, that's the difference, ha ha ha.....
billytickets
Billytickets - 6 years ago
armetofo. YOu and me are BOTH "smart" enough to be "loading" up on JNJ. With all this volitality in the market doesn't these low PE HIGHROE ROC stocks high concentration portfolio look Pretty good now.
billytickets
Billytickets - 6 years ago
Altria is on the move today and is "rumored" to announce the spin off of international and a divdend increase which billytickets himself "predicted" earlier in the summer. On August1st i mentioned that MO got as low as 63 but since i am very "overweight it" I passed.Did anyone add any MO during this market downturn?
billytickets
Billytickets - 6 years ago
For those who predict a"low PE" for WMT. Check out how dow stocks with PE's at 15 or less behaved in the last 7 years
mikehotchin
Mikehotchin - 6 years ago
Hi guys, I started my investing in the stock market just in december 2006 and have read The Intelligent Investor and half of Security Analysis by Ben Graham. I have concentrated my portfolio in the same way billytickets has but with a bit more stocks. 7-10 stocks with portfolio value around 150,000. I do not use margin.

What I have realized in 7months is that billytickets approach to the market is fantastic. High Quality stocks with a high ROE and high dividend payouts purchased at LOW p/e levels is the way to go. Adding to a concentrated portfolio of these stocks when they are at LOW historical levels is the way to "beat the market" while enjoying fantastic dividend income and safety. I noticed that always you can find these quality stocks for sale at a certain point. This is the time when you add to long positions. I intend to hold a quality portfolio of maximum 10 issues for 10+ year period while adding to these positions when the price is LOW. I believe this is the MOST IMPORTANT step.

My current portfolio: BAC USB RY ZNT JNJ GE WMT ECA BUD
bynelius
Bynelius premium member - 6 years ago
Hi,

Its a pitty that media uses the price earnings ratio because it doesn´t take into account the cash situation. A company with earnings of 10 and a price of 150 has a P/E-ratio of 15. If the company has 80 in cash and no debt the price earnings ration is a bit misleading ;-)

JB
bynelius
Bynelius premium member - 6 years ago
Hi again,

I personally use the EV/EBIT instead of P/E.

/JB
billytickets
Billytickets - 6 years ago
Explain EV/EBIT for our readers please
billytickets
Billytickets - 6 years ago
Dont you wish this was your formula?
valuemodel
Valuemodel - 6 years ago
WS, Jr., asked me to read this, so here are my comments.

The metrics are related to the ones I use. I tend to use ROIC and EV to EBIT myself (except for banks). I narrow down my list based on other valuation characteristics (P/BV, P/S, P/average 5 to 10 year earnings).

I'm a little "stingier" than WS, maybe I need to reconsider my position in light of the results. T

Thank you very much for taking the time to do this little analysis.
billytickets
Billytickets - 6 years ago
Valuemodel it is clear you are very analtcal and will be an asset to the overall brain power of this forum Check out these articles and provide HONEST analysis thanks [www.gurufocus.com]

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