Superlon - from a PE perspective

Price Earnings (PE) ratio is one of the most commonly used valuation metrics by investing community to assess whether a company is undervalued or overvalued or to give us an indicative intrinsic value of the company/business.

Price Earnings ratio = Price (P) / Earnings (E)

In a nutshell, it tells us how many years for us to recover our investment if we invest in company or how much you are willing to pay per dollar of earnings.  The inverse of PE ratio is the Earnings Yield.

Eg, if we invest in a company that is trading at Rm1.2 per share and its Earnings Per Share (EPS) is 15 sen,  the PE of the Company is 8, earnings yield = 0.15/1.2 = 12.5%. Meaning it will take us 8 years to recover our Rm1.20 investment (don't forget we still hold the shares, at zero cost now), with the assumption that the company continue to earn 15 sen per share.

Generally, the lower the PE, the cheaper it appears. Please take note, it may also means that investment community do not think the future prospect of the company is good ( most of the time, Mr Market has priced in the company’s future prospect but at times, Mr Market can be mad in pricing too – either unreasonably high or low). Hence even it is trading at lower PE now, it may turn out not so later as the company may be in a sunset industry and its earnings may be on down trend already or may consists of one off gain in earnings.

There are few PE variants commonly used:-

1. Historical PE where we use the last FY earnings
2. TTM(trailing twelve months’ results) PE where we use the latest 4 quarters results
3. Prospective PE – try to use future earnings or growth guidance provided by company
4. Some would just use the latest quarterly results and multiply by 4 to arrive at its prospective earnings and hence its PE ( This will only be reflective if the earnings are stable and not in sectors that are cyclical in nature).

Advantage of PE ratio as valuation metrics

1. Simple and easy to understand
2. Easily available

Limitation of PE ratio

1. Time value of money not considered
2. What about the growth prospects in future
3. How to value loss making company which has no historical earnings
4. Not easy to compare against different industries
5. May have one off gain/(loss) in the earnings

How do we know at what PE is cheap or expensive?? Well, it seems that the followings are used to compare companies :-

1. Industry/Sector that it is in, what is the average PE
2. Growth prospects
   
   

For instance, Technology companies command higher PE as most believe this sector has higher growth rate, Telco & consumers stocks seem to have higher PE than industrial, property or plantation as they are viewed to be more stable and not too cyclical.

My personal view is that it should not be used rigidly as businesses are changing where stable business may not be so stable (eg offline retailing use to be stable until it is disrupted by ecommerce, bank used to be stable and it may now be threatened by various innovative fintech companies). I would place more emphasis on whether the management can continue to innovate and be competitive all the time. Hence, in my opinion, good companies with strong management should be accorded a higher PE too.

Price Earnings Growth (PEG)

PEG = PE/ Growth %

The lower the PEG, is an indication that the company is trading at “lower” valuation given its growth prospect. The followings are used to illustrate how PEG can be used to overcome one of the limitations of short term view of PE (please always bear in mind, there is risk of over or underestimate the future growth that can cause us to buy a stock that turn out to be overvalued/ undervalued)

Company A  (Current PE 10, growth 10% pa, PEG =1)
	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Price	1.5	1.5	1.5	1.5	1.5	1.5
EPS	0.15	0.17	0.18	0.20	0.22	0.24
PE	10.0	9.1	8.3	7.5	6.8	6.2
Company B (Current PE 30, growth 60% pa, PEG= 0.5)
	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Price	3	3	3	3	3	3
EPS	0.1	0.16	0.26	0.41	0.66	1.05
PE	30.0	18.8	11.7	7.3	4.6	2.9
Company C  (Current PE 10, growth 20% pa, PEG =0.5)
	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5
Price	1.5	1.5	1.5	1.5	1.5	1.5
EPS	0.15	0.18	0.22	0.26	0.31	0.37
PE	10.0	8.3	6.9	5.8	4.8	4.0

Purely from PE comparison (without considering the cashflow and financial position eg gearing level, cash in hand, no of shares, size of the company, etc)   we can conclude that:-

Company A vs Company B

Company B appears expensive (higher PE) now but it is a high growth company, after 3 years, it will appear cheaper than Company A ( as shown by lower PEG in B). However, the risk – can Company B sustain its growth??

Company A vs Company C

Company C appears better as it has lower PEG and 1 year later, it appears cheaper than Company A and if the growth can continue as projected, it will get cheaper and cheaper.

Company B vs Company C

Though both Companies have the same PEG, company C appears cheaper in first 3 years as the high PE for Company B requires consistent high growth (60% vs 20%) to catch up.

My own guideline is always going for low to moderate PE with reasonable growth assumption as high PE (eg more than 30 times in Company B) really required very high and consistent growth and take longer for me to recover my investment. Obviously investors in high growth technology (eg Amazon PE 184) will not agree with this and even some high tech companies without profit for years (eg Tesla , loss making but with high expectation that it will be very profitable in the future) command much higher valuation than many other profitable companies. Yes, nothing is absolute in investment and no metric is the perfect valuation tool as we are talking about the uncertain future.

PEG ratio is useful to compare companies with different growth prospects. To evaluate whether a growth company deserves a higher PE, I always bear in mind that expectation of growth should be based more on reasonable assumptions (eg is there any expansion plan, new products launch, etc ) not just based on hope.

PE is a useful indicator but not the ultimate or most reliable metric as there are other metrics (Discounted Cash Flow, EV/EBITDA ) to measure the value of a company/business for company that may have moderate PE ratio but ability to generate strong cashflow – eg companies that may have invested heavily in the past and are now enjoying the fruits with very little capital expenditure needed now.  

I tend to agree with the popular saying that valuation is more art than science, especially when it involves so many aspects of the business – the quantitative as well as qualitative aspects. It may look expensive to you but cheap to another person or vice versa but eventually it may get closer to what most people think what is its fair value.

Let’s take a look at Superlon’s case,

Historical PE (based on FY 16) =3.59/0.21 = 17.1

TTM PE = 3.59/.265 = 13.5

PE based on earnings using latest quarterly results x4 = 3.59/ (4x 0.788) = 11.4

Prospective PE (FY18) = 3.59/.35 = 10.3

(assuming a 30% growth in profit for FY18 based on TTM profit, I believe it is not too aggressive as profit growth for the last 2 years were more than 50% and 2017 growth expected to be at least 30% , in addition, the new warehouse and expansion in Vietnam strengthen the growth prospect)

As investment is about the future of the company, historical PE is definite and more reliable for company with stable earnings and little growth. For growth company, prospective PE would be a better measure (of course it involves the risk of over/under estimate the earnings growth).

What is the “fair” price for Superlon??

I like to compare it with Wellcall, which is trading at TTM PE of 23.

Is the expected growth rate excessive? Is it supported by more solid assumptions?

Prospective PE of 10.3 is still attractive. I believe 30% growth assumption for FY18 is achievable given the new warehouse would be fully operational ( MIDF projected growth of 10-20% in capacity for Superlon) and expansion in Vietnam may contribute as well.

Its really your guess versus mine but for now, I will continue to hold as based on prospective PE, it does not seem overvalued and I am looking forward to the contribution from new warehouse  as well as from the Vietnam expansion. End of the day, management's capability to deliver results should be accorded a higher PE than comparing to industry's PE in general.