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Relative P/E's: Nonsense squared?

Relative P/E's: Nonsense squared?

I had a call yesterday from one of my brokers (who also happens to have become a friend). He informed me that the restrictions have come off all the broker’s so that they are now able to write research about Myer. As you would expect so soon after its widely supported float (A float that lost money for the thousands of investors who sold out in the first weeks), the research has been predictably bullish. It is not however the views of the analysts that is interesting. What is interesting is the reference in several of the reports to a relative P/E. The argument goes that because Harvey Norman and David Jones have a higher P/E than Myer, that the gap should narrow and Myer’s P/E should rise, pulling the price up with it. See any weaknesses in the logic?

Its like saying that there’s a Ferrari and there’s a VW Combi and the VW combi will get faster because the Ferrari is too fast compared to it.  Clearly such conclusions are flawed.

The performance of management, the economics of businesses and their prospects all affect their values and the sentiment towards them, which in turn, affects prices in the short term.

Buffett has frequently said that academics where correct in observing the market was frequently efficient.  In other words, a lot of the time, the price is right and perhaps in the case of Myer it should be on a lower P/E than David Jones.  This post should be read in conjunction with my previous posts on Myer that discuss its intrinsic value.

Roger Montgomery, 10 December 2009.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.


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  1. Hi Mario, It may be difficult for the lay person to value these companies as Warren Buffett does for the following reasons:

    1) WB will look at the true value of the company as if he owned it outright, if you look at his berkshire annual reports he shows that company with a reported book value of $20B is actually worth $40B to him.

    2) WB buys substantial positions in companies if not outright, this gives him some influence over the way the company deals with its assets. most of us don’t have that luxury.

    So if WB can buy a business or part of a business with say $40B in assets for say $20B then get management to deal with those assets in a different way he profits. Think of the recent Myer float TPG did a similar thing.

    Alas many of us don’t have that clout, therefore a good buy for WB may not be as good for me.

  2. I made a few adjustments by calculating my own ROE, which was simply Net Income/Total Stockholder Equity. The results varied in most cases:

    Exxon: 40.03% (v.s. Yahoo’s Estimate of 19.80%)
    Wall Mart: 20.53% (v.s. Yahoo’s Estimate of 20.30%)
    Wells Fargo: 2.39% (v.s. Yahoo’s Estimate of 6.10%)
    Alexander&Baldwin: 12.31% (v.s. Yahoo’s Estimate of 4.40%)

    This might be due to the time difference as the balance sheets and income statements on Yahoo are year-end 2008. But this variation in ROE (Exxon) shows how important it is to use other measures to study the business to back your ROE formula. As Buffett recently said in relation to his Burlington purchase: it was “not a bargain”.

  3. I agree with Roger. Listening to some of Warren’s recent comments, I expect he is happy to set his required return well below 15% – this, along with adjustments for retained profits, would change the valuation (equity multiple you are willing to pay) considerably.

  4. Talking about Buffett and ROE, I recently tested the intrinsic value formula on some of Buffett’s investments.
    I the formula ROE/15% *EQPS on 4 companies whom both Soros and Buffett recently invested in. They include Wall-Mart, Exxon Mobil, Wells Fargo and Alexander&Baldwin. The results were striking. When using ROE (and not expected ROE since I don’t know what their expectations are), I got the following intrinsic values:

    WMT: $22.89 (vs. a current price of $54.05)
    Exxon: $31.39 (vs. a current price of $72.79)
    Wells F: $8.59 (vs. a current price of $25.96)
    Alex: $7.66 (vs. a current price of $32.60)

    I realised that they must have a fairly high expected ROE to see these companies as good investments. So I substituted the price for the intrinsic value to find the ROE they expect on their investments. The results were as follows:

    WMT: 47.94% (vs. a current ROE of 20.30%)
    Exxon: 45.91% (vs. a current ROE of 19.80%)
    Wells F: 18.43% (vs. a current ROE of 6.10%)
    Alex: 18.72% (vs. a current ROE of 4.40%)

    These seem incredible yearly returns on shareholder’s equity. But this got me to wonder about the core of the equation, which is EXPECTED ROE in the medium-term. What are ways an investor can determine what ROE to expect? I’m hoping to find some clues in Graham’s Security Analysis. When asked about it on CNBC a while ago, Buffett responded: “that’s the trick”.

    • rogermontgomeryinsights

      Hi Mario,

      Well done! Good work. ROE however is not the only variable. The required return (RR) you use could also have something to do with the vast difference but I have to confess again that I am taking you to the river I fish in but not my fishing hole. Think about Coke; you know its got sugar but not how much nor every ingredient. Buffett in 1981 discussed the approach I adopt and he also mentioned that the assumption was that a company paid out 100% of its earnings as a dividend. But the companies you mention retain some of their profits and only pay a portion out as a dividend. The formula must therefore be modified for a company that retains and compounds its earnings at the rate of return on equity. Clearly a company that retains profits and produces a 20% return on the incremental equity is worth more than a company with the same beginning equity but which earns 20% and pays all of its earnings out to us as a dividend. If the company keeps the money it will get 20%. If we receive the money we won’t get 20%. We expect to get a lower rate and this is reflected in the discount rate. In my forthcoming book I provide all the steps to follow to apply to companies that retain some proportion of their profits.

      • Thanks, I’ll be waiting for that book.

        Time Clare, I tried different required rates of return and it did not make much of a difference. To get the intrinsic value to equal the price paid for the stocks, the required rate varied between 4% and 7%. As Roger mentioned, the key is retained earnings. There is also the prospect of an economic recovery which should boost the ROE over the long run. The calculation is definitely not as simple as one formula, but it is a start.

  5. Exactly. It assumes that “a rising tide lifts all boats”, like ‘the VW will get dragged along in the Ferrari’s slipstream’ because of the ‘voting machine’ dynamics. Yes, but the rising tide also drags up a load of junk with it too, like the mining boom did to resource companies that were essentially just four pegs, a dog, a shovel and a ute.

    When that happens, the water becomes murky – true value becomes harder to find because the sector is ‘hot’ and attractive buying prices become harder to find too. Conversely, maybe time to sell ?

    Dangerous sentiment, because we all know how fickle the market is in the short term either way, and the rising tide can quickly run back out again with no warning.

    • rogermontgomeryinsights

      Hi Chris. You’ve got it! And as someone once famously quipped: Its only when the tide goes out that we see who was swimming naked.

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