The Use and Misuse of the Price Earnings Ratio

And Interserve PLC

Courtesy Wikipedia

We like to keep things simple. A long time ago, investors settled on the price-earnings ratio (P/E ratio)* as an indicator of how a share was valued by the market. Naturally, the flaws in the denominator of the P/E ratio, earnings per share (EPS), drove investors to look for indicators that are more meaningful. *The P/E ratio = the market price per share X number of shares outstanding/ post-tax profits.

Yet the P/E ratio is not a silly number. As the numerator of EPS is profit after tax, it cannot be ignored. Profit after tax determines, via the balance sheet account of retained earnings, the funds available for distribution to shareholders as dividends. And management often decides the company's dividend based on a fixed percentage of EPS.

The P/E ratio is just one of many measures used to value a company. It is often misused either as a substitute for further analysis or by quoting a figure based on management's 'adjusted' earnings. Management often adjust earnings to exclude amortization, depreciation and impairments to intangible assets and/or non-recurring or exceptional items. This usually inflates EPS and consequently understates the true P/E ratio for the company's shares.

 But the P/E ratio is very useful for measuring aggregates - entire stock markets.

Robert Shiller, a glutton for statistics, showed in 2005 (Irrational Exuberance 2nd Edition)what every investor already took for granted ". . . investors who commit their money to an investment for ten full years did do well when prices were low relative to earnings at the beginning of the ten years." Shiller favours the Cyclically Adjusted Price Earnings (CAPE) ratio as a measure for an entire index, which is a ten-year rolling average P/E ratio.

The following table illustrates the Shiller CAPE for the S & P 500 going back to 1880 (S & P 500 to 1926 and extrapolated backwards) plotted against long-term interest rates. From this graph, one concludes that there is no constant relationship between interest rates and the stock market, except that since the 1980s interest rates have a positive correlation to CAPE but with a lead-time of between 10 and 20 years. According to this measure, the S & P 500 is not far from its long-term mean. (I am not aware of any similar long-term study for the London Stock Market.) 

 

Graph courtesy of Robert Shiller at his Yale website, click to enlarge.

Goldman Sachs has also produced results, based on CAPE and the forecast P/E ratio for 2013, for 17 major stock markets as of February 2013. The UK stock market was then at a lower valuation than the average for the last 38 years. This is a most useful measure for investors interested in foreign markets, where they plan to invest via a fund.

Table courtesy of Goldman Sachs website, click to enlarge

And this week's Buttonwood column in the Economist uses comparative P/E ratios to show that emerging-market equities are at a 25% discount to developed-world equities. Buttonwood comments, "They [emerging-market equities] have been cheaper in the past, but a further period of underperformance will make them very attractive to long-term investors."

To conclude, the P/E ratio is a useful measure for stock indices, given the few alternatives (dividend yield, price to net assets ratio) available. But given the large amount of financial and non-financial information available for individual companies, the P/E ratio is a really poor measure of that company's value.

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Interserve PLC

Courtesy Wikipedia

Interserve is in an unfashionable business (support services to the public sector mainly) and relies for two-thirds of its profit on the stagnant UK economy. The shares stand on a current P/E ratio of 10, half the level of the FTSE 250 (of which Interserve, with a market cap of 610 million, is a component). They yield 4.4% compared to the FTSE 250's average of 2.6%. Interserve's share price has underperformed the FTSE 250 these past 5 years:

Graph courtesy of Yahoo, click to enlarge

Yet Interserve is financially strong and has a good trading record. Consider:

1. After the sale of its interests in PFI (Private Finance Initiative), the company has a net cash position of 27 million pounds at the end of 2012.

2. Interserve's ordinary free cash flow for the past five years, after capital expenditure and paying the dividend to shareholders, left 30 million pounds for acquisitions and reducing debt.

3. Interserve's dividend is twice covered by earnings and has grown by 4% p.a since 2003.

4. Return on equity averages 19% and, on retained earnings these past 10 years, 27%.

5. Ordinary earnings per share have grown by 11% annually and equity per share by 15% annually since the period 2003-5.

6. Business in hand, at 6.3 billion pounds, is the equivalent of 3 years' revenues.

Interserve has a stable management team with the CEO in office since 2003, the Chairman since 2006 and the CFO since 2010. Management has pursued a strategy of:

1. Moving away from construction to support services (over a wide range of activities), where longer contract periods guarantee more stable revenues. However, business in hand at the end of 2012 was no greater than in 2008.

2. Moving into new areas that promise more growth. However, the business sectors served by Interserve are not substantially different from 2004:

                               Sector                                  % Revenues 2012            %Revenues 2004

                               Commerce                                   21%                                     23%

                               Defence                                        20%                                     13%

                               Infrastructure                              16%                                     17%

                               Health                                           13%                                     11%

                               Education                                     10%                                       6%

                               Other                                             20%                                     30% 

3. Increasing the share of international business, dominated by the Middle East, where margins are triple those in the UK. Interserve has increased its international revenues from 8% of the total in 2004 to 33% in 2012. However, operating margins have hovered between 4 and 5% for the past 5 years. 

4. Doubling earnings per share between 2011 and 2015, to about 80p a share. 

To achieve this objective, in 2012 Interserve sold its substantial PFI business and bought a number of companies to extend its business in welfare-to-work (for the UK government), home healthcare and oil and gas services to the Middle East. 

On conservative assumptions*, my valuation model values Interserve at 486p a share, or about the present market price of 470p. *For the years 2013-17: 11% p.a. increase in EPS, 10% p.a. increase in equity per share, 19% return on equity, and an average P/E ratio of 9. Discounted by 12.3% to allow for the execution risk associated with these assumptions. 

Interserve, at its current share price, offers a superior and well-covered dividend that in the past has more than kept pace with inflation. 

The cautious investor will note: 

1. Interserve has made a significant move from its profitable business in PFI to increasing its business elsewhere. This is not guaranteed to succeed. 

2. The company relies on UK public spending/outsourcing for a large share of its business. 

3. The shares have been as low as 292p in the last 12 months (20 June 2012). 

4. Four directors have made large sales of their shares in April at 475p a share. 

5. Although the company closed its defined benefit pension scheme to new entrants in 2009, its liability is growing. In the latest year, the company handed over 55-million pounds of PFI projects to its pension fund to fund a part of the deficit. This is equivalent to 70% of its 'headline' profits for 2012. Future payments have been agreed at an 'indexed' 11 million pounds a year. This will prove to be a drag on profits and dividends.