Budi Frensidy: Five Limitations of PER
Nino Eka Putra ~ FEB UI Public Relations Officer
DEPOK, Monday, 20/7/2020 – Kontan daily published an article written by Budi Frensidy, professor of finance and capital market at FEB UI, in the Portofolio – Wake Up Call column, page 4, entitled Five Limitations of PER. Below is the article.
Five Limitations of PER
A look at the price-to-earnings ratios (PER) of the stocks on the LQ45 index at the end of last week showed that the PER of the 10 stocks with the lowest PER -after removing stocks with negative PER- ranged from 2.8 times to 6.8 times, with an average of 6.1 times. Meanwhile, the PER of 10 of the most expensive stocks range between 24.4 times and 81.8 times, or an average of 35.7 times, if an outlier of more than 100 is not taken into account.
Why do the actual PER of LQ-45 stocks that have passed tight screening vary greatly (2.8 – 81.8)? Why aren’t cheap stocks being sought after by investors and expensive stocks still selling? Why didn’t PER converge to the consensus figure of 15?
All roads lead to Rome. Similarly, we also know that there are many models of stock valuation. There are single-period Vs. multiple-period models, absolute value Vs. relative value models, and cash flow-based Vs. accounting-based (accrual) models that use earnings per share (EPS) or book value. Cash flow can be in the form of dividends, operating cash flow, free cash flow (cash available for a company), and free cash flow to equity. Based on the grouping above, PER is an accrual-based single-period model (EPS) for finding relative values using price multiples.
With PER, investment decision is not about looking for stocks whose value is above their price but rather to choose shares whose fair PER is above the actual PER of the shares in the market. Buy stocks whose fair PER is higher than the actual PER and sell shares if the fair PER is lower than the actual PER.
PER is preferred because it is easy to calculate and interpret. Apart from being practical, PER can also be analogous to the payback period, which is very popular as a criterion for investment in real assets. Assuming the dividend payout ratio is 100%, investors who buy shares with a PER of 10 will recover their capital within 10 years.
Besides its advantages and practicality, PER has five limitations. First, the net income figures used are accounting products that are based mainly on estimates, assumptions, methods, and policies chosen by company management. Second, PER is a single-period valuation based on profit in a specific period.
To understand the other three limitations, let us look at the simplest absolute stock valuation by using available cash flows. There is no need to make prior calculation like other cash flows as in the dividend discount model. Based on this valuation model, the fair value or price of a share is the present value of the dividends it generates in the future. Here’s an example.
What is the value of a stock that pays a constant $150 dividend each year? Assume that the return that investors expect for this stock, based on CAPM or other models, is 15%. The answer is value = (dividend/expected rate of return) or Rp150/15% = Rp1,000. If the market share price is below Rp1,000, it is recommended to buy and vice versa, sell if the price is above Rp1,000.
Stocks with constant dividends are preferred stocks. There are only a handful of them with nearly zero sales, and stocks whose net income is stagnant. Investors who seek capital gains don’t like these stocks. If the dividends increase by 10% per year, what is the fair value or price of the shares?
The equation for that, known as the Gordon model with g growth rate and dividend for next year D1 is P = D1 / (k – g). Next year’s dividend is Rp150 (1 + 10%) = Rp165, so the value of this share will be Rp165 / (15% – 10%) = Rp3,300. Because it promises to grow, investors will be willing to pay triple the initial price or spend an additional Rp2,300 to buy growth.
Back to the PER problem. If we divide the Gordon equation by EPS, we will get P / EPS = (D1 / EPS) / (k – g). The left side of the equation, namely P / EPS, is nothing but justified PER and the right side is the three factors that influence it, namely D1 / EPS or dividend payout ratio, discount rate (k), which reflects stock risk, and growth rate. This means fair PER is positively related to the payout ratio and growth and inversely related to risk (discount rate). Therefore, we can also outline the last three limitations of PER.
First, low and high PER assume the same growth rate for all issuers. In reality, growth rates are different and because of this, many investors are still willing to buy stocks with high PER. Second, low and high PER ignore the differences in risks faced by issuers, both financial risks due to large debts and business and industrial risks as well as risks due to the Covid-19 pandemic. These risks can lead to a decrease in net income in the coming period so that PER will increase and share prices will no longer be cheap. Third, the average PER also does not take into account the difference in dividend payouts. The threat of a big risk and a very low payout explains why the cheapest stocks with low PER on the IDX are still not attracting investors.
In conclusion, a stock with a low actual PER is likely to have a reasonable PER around that figure so that it cannot be said to be cheap. For stocks with high PER, investors may anticipate higher EPS growth in the future. Finally, the fair PER turns out to be the value divided by EPS. Therefore, the relative PER method and the absolute value discounting dividend model are like the two sides of a coin. Both use the same formula, namely the Gordon equation. (hjtp)
Source: Kontan daily, Monday, 20 July 2020 edition, Portfolio column – Wake Up Call, page 4.
(lem)