Understanding PE Ratios: It’s About Confidence

This story features ARISTOCRAT LEISURE LIMITED, and other companies. For more info SHARE ANALYSIS: ALL

By Rudi Filapek-Vandyck, Editor FNArena

Assuming no unforeseen scenarios, Australians will vote on September 14 to either keep the present Labor government in power or to replace it with a conservative coalition of Liberals and Nationals. As things stand right now, conservative Tony Abbott is a strong favourite over Labor's battle-hardened Julia Gillard.

You don't have to necessarily agree with Abbott's favouritism, and certainly Gillard would like a few things to say about it between now and September 14, but current sentiment is unmistakably leaning towards a change in government. This general sentiment is also reflected in the odds offered by bookmakers and betting companies. According to a recent press release, bookmaker Tom Waterhouse is taking on election bets with odds at $1.16 for an Abbott win and $4 in the case of a Gillard victory.

These odds will change as new developments take place and maybe sentiment can still shift in favour of Gillard, but as things stand right now there's not much to gain for punters backing the general favourite. Betting on Julia Gillard winning the contest seems so much more lucrative, but there's a very good reason for this: only true Labor supporters and unionists think she can pull it off.

I usually don't like drawing parallels between gambling and the share market, as I do believe there's a BIG difference, but in this case I think the comparison is apt and very much to the point, because the same principles that govern today's gambling odds for an Abbott or Gillard win apply every day in the share market.

Take Aristocrat Leisure ((ALL)) as an example. Shareholders in the poker machine manufacturer haven't had much joy post-2007. Profits and dividends had kept on declining year after year and this was reflected in a gradual de-rating as investors' confidence evaporated along the way. Aristocrat became the target of short sellers and its Price-Earnings (PE) ratio fell from around twenty to less than ten. What this effectively meant is the company had started to look more like Gillard than Abbott and the low PE was a reflection of this. Low PE means low confidence, thus high risk.

Some gamblers might argue that $4 against $1.10 in the contest Gillard-Abbott is too wide, and that might well be the case, but unless something feasible happens that shakes up the political landscape, Tom Waterhouse is unlikely going to substantially change his odds. It's no different in the share market where, arguably, valuing Aristocrat shares at less than $2.40 per share (August last year) was too low a valuation for a company whose fortune was turning around. Usually, investors want to see some evidence, no matter how flimsy, that things are indeed improving and that general low confidence is no longer warranted.

In recent months general sentiment towards Aristocrat has improved, and quite a lot, as the market started to realise the company's profit profile was about to turn for the better. This view was confirmed in February with a 35% growth in earnings per share for the year to December. Today investors are convinced this company is looking towards much better times ahead than what has transpired between 2008 and mid-2012 and this confidence is reflected in today's PE ratio of 19x times prospective earnings. On current consensus estimates Aristocrat will achieve 14% growth in earnings per share this year and growth of 19% next year.

Aristocrat's PE of 19 shows there's little doubt in investors' minds these growth projections will be achieved. What if profit growth is likely to be even better? Expect the PE to rise above 20 if the market grows confident this will be the case.

Most of the time investors hear from market commentators and other financial experts that PE ratios show what the value is of shares and thus certain shares are overvalued while others are undervalued. This is only true as a second derivative from the market's confidence that is primarily responsible for these PE ratios.

It can easily be argued that, because of current expectations about who's likely to win the elections in September, Tony Abbott is more valuable than Julia Gillard. Imagine yourself a business owner who's about to lobby for an important future project. To whom would you direct most of your attention?

It's the same in the share market: were Tony Abbott a listed company, his PE ratio would now be well above 20 (possibly around 30) and Julia Gillard's would be well below ten (unless she promised to pay a big dividend). $1.10 against $4 is simply another metric for showing the same thing.

Being confident is not the same as being right. As a matter of fact we, the people behind these PE ratios, sometimes become absorbed by our own confidence; that's when we become over-confident and risks start accumulating in the opposite direction.

The Australian Open tennis tournament earlier this year provided one such fine example. When the world's number one, Novak Djokovic, was to play Swiss challenger Stan "The Man" Wawrinka in the fourth round, nobody believed Djokovic would not advance to the quarter-finals. As a result, betting odds were similar to Abbott-Gillard's. At least, that was the case before the game had started. Once Wawrinka unleashed his super-form on Djokovic those odds started changing rapidly. Ultimately, Djokovic still managed to win, but it had been a tight contest overall; it could easily have gone the other way. By the time the world's number one won the final set in 12-10 after five hours of high quality tennis, betting odds had narrowed substantially.

In the share market, online real estate portal REA Group ((REA)) is growing annual profits by 25% or more per annum. This is quite rare in an overall environment whereby banks grow in single digits and profits for resources stocks are extremely volatile and uncertain. In such an environment, it shouldn't surprise investors have flocked together into REA Group shares. Not one of the stockbrokers covering the stock has a price target above today's share price, but that still doesn't deter investors. Is a PE of 32 too high?

It depends. If REA Group continues growing at 25% per annum then today's PE of 32 will drop to 26 on FY14 prospects and even lower on estimates for later years. If the only option is between Gillard and Abbott and you must place a bet, you probably still put your money on Abbott, unless Gillard's chances genuinely start improving, after which you might re-consider (see Djokovic-Wawrinka earlier).

Sometimes investors' confidence changes focus. At the peak for the Australian share market in 2007, CommBank ((CBA)) shares were trading on a PE above 15, which is historically as high as PEs go for an Australian bank. In hindsight, it turned out investors weren't confident at that time, they were dead right complacent, punch-drunk, over-confident and maybe even a little bit delusional. Fast forward to today and CBA's PE has again risen above 15. This time, however, investors' focus is on the bank's dividends and one can only acknowledge there doesn't appear to be much of a threat to those dividends.

Today's PE thus reflects a high level of confidence those dividends will be paid. Should the market become more confident about an extra-bonus for CBA shareholders in 2014, this will translate into an even higher PE. Alternatively, were Gillard's chances for re-election to genuinely improve in the months ahead, more gamblers might consider backing her odds instead of the low profit-generating Tony Abbott.

This shows us as to why resources stocks haven't been able to catch-up with banks and industrials thus far. They're still at Gillard-Wawrinka odds and investors' confidence is too low to shift away from backing Abbott and Djokovic.

Any comparison between the share market and gambling is incomplete without pointing out the major difference between the two: a gamble on Wawrinka, despite his epic battle, would have still resulted in a 100% loss. Unless you really don't know what you're doing, this is virtually never the case in the share market.

Shares in BHP Billiton ((BHP)) were approaching a PE of 15 on FY14 consensus estimates in February. It is clear the market wants to believe BHP's earnings growth will resume next year and management might even surprise with cost cutting and other shareholder-friendly initiatives, but it's difficult to keep confidence up when spot iron ore appears unsustainable, crude oil prices are going nowhere and serious question marks are being raised about supply-demand prospects for copper.
 

(This story was written on Monday, 25 March 2013. It was published on the day in the form of an email to paying subscribers).

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Rudi On Tour in 2013

 – I will present and contribute during the 2013 National Conference of the Australian Technical Analysts Association (ATAA) at the Novotel in Sydney's Brighton Beach, June 21-23

– I will present to members of AIA NSW North Shore at the Chatswood Club on Wednesday 11 September, 7.30-9pm

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