I constantly stress that we need to buy the best quality companies for our long-term investment portfolios. But having found that great share, the second part of the equation is what price we should pay for it. Some will argue that you should buy regardless of price, but I disagree. A great company at a bad price is a bad investment. We need to get a great company at a great price to see our long-term portfolio do well.
The problem is: what is a great price? Some people will use discounted cash flow (DCF), others will look at the price-to-book ratio (P/B) or use variations of the dividend discount method. At the end of the day all these methods are subjective, and in all cases one must make many assumptions about profits, growth, margins and more. Every time you assume something, you add risk to your prediction, as that assumption could be wrong.
So, I keep it simple, very simple. I generate a chart of the historic price-to-earnings ratio (P/E) over the last seven years, and look to buy when the forward P/E is below the seven-year average. I use seven years as this is a full economic cycle.
The first point is where to find the data. I get the P/E ratio at every year-end and interim period from my online broker. If your broker does not offer this information, you’re going to have to do some digging. Google Finance will provide the price at every period end and in the results you’ll find the headline earnings per share (HEPS) numbers, and you can then calculate your P/E for the end of every period.
Drop this data into Excel and generate the average for the seven years (14 data points) and you’ll get a chart like the one on this page for Woolies*. Here we can see that the average P/E over the last seven years has been 18.9 times, and I will consider buying if the forward P/E is below this level.
The forward P/E is generated using the current share price and next year’s expected HEPS. Again, my broker provides consensus forecasts for future earnings, but if yours does not or if the share you’re looking at is not covered, you can make a rough estimate. Be conservative rather than optimistic.
Using Woolworths as an example
Here the forward P/E is around 14.8 times, so at a current price of 7 200c, my system considers Woolies to be offered at a great price to buy. I take this a step further by asking up to what price I’ll be prepared to pay for Woolies shares. Here the formula is average P/E / forward P/E * current share price, where average P/E = 18.9 times, forward P/E = 14.8 times and current share price = 7 200c. This equates to: 18.9 / 14.8 * 7 200c = 9 195c. So, I will buy up to 9 195c.
Let’s do the same using this bank. Average P/E is 16.2 times and forward P/E using its recent trading statement is around 23.5 times. So, at the current price of R758 the formula is 16.2 / 23.5 * R758 = R522. That R522 is the price at which I would buy Capitec and for now I wait, not adding to my Capitec position.
The buy price will change as new results come out and as forward expectations change. Very importantly, this buy price does not mean that the price cannot
fall further; with Woolies we see that the current price is well below my buy
price. This buy price I consider fair value and I will stagger my buying over
time below the fair value price.
The method is quite rough and any forward predictions are far from perfect, but it has served me well over the years.
*The writer owns shares in Woolworths and Capitec.
This article originally appeared in the 30 March edition of finweek. Buy and download the magazine here.