Low Price Ratios
It is a well know fact that low price ratios are indicators of strong future returns; one of the most watched (but in my view one of the most inconsistent) ratio is the Price to Earnings or PE Ratio.
This ratio is the share price divided by the firms earnings per share – effectively their net profit per share – the higher this ratio goes is an indicator of what investors are willing to pay for future growth. When investors get carried away with markets they are willing to pay more and the opposite happens when sentiment turns away from equities.
In image one are some examples using PE’s for some well known firms in the UK FTSE-100.
From this we can that 2006 say BAE reach its high of 26.1x and in 2007 Rio Tinto was at 19x; the next few years were not great for shareholders with BAE 41% lower by mid 2011 and Rio Tinto down 78% by the end of 2008!
On a brighter note we can look at 2008 in graphical format (image two) as there are five shares that were all trading at low PE ratio’s – returns for shareholders were much better across the board with returns anything from 15% to over 150%.
The same approach can be applied using low Price to Book, Price to Sales and Price to Cashflow – invariably the probability of success is weighted in your favour.
So why doesn’t everyone use it………………….?
The answer is human nature; to be successful at the approach takes a different mind set and the ability to ignore the latest news or hype around what the media tells you are missing out on. Ultimately it also takes patience and you can spend long periods waiting for the right conditions or for the recovery to happen………..but when it does its worth it.
Two years ago we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking!
Scott Mcnealy CEO of Sun Microsystems in 2002 talking about the price to sales ratio of the firm
