In the world of investing there are many different styles and strategies; however, when investing in stocks there are typically two primary ones: Growth and Value. For simplicity, Growth investors are generally looking for companies with excellent future prospects and often can be found in emerging markets and the technology sector. On the other hand, Value investors look for companies that are cheap and likely fallen out of favour. Perhaps they had a lawsuit, poor earnings, tariffs, loss of key person or their industry is out of favour. As a matter of interest, Warren Buffet, is considered a value investor.
Arguably the most common way to evaluate and compare stocks is to look at their respective Price-Earnings (PE) ratio which is calculated:
current share price
earnings per share
As an example, Bank of Nova Scotia (BNS) recently traded around $70.00 a share and had earnings per share of $6.84 for a multiple of 10.2 times. In addition, Scotia currently pays the highest dividend yield of all banks at 4.8% or $3.40 a share.
Generally, if a stock trades at a high PE then investors have high expectations or earnings were low. Here are some favourable and unloved companies:
There are several other metrics and factors to consider but using a PE ratio allows for a quick comparison. For example, if BNS Bank trades at a PE of 10x that suggests that over the next 10 years (assuming constant earnings of $6.84 annually) that an investor would be paid back their original investment which is a return near 7%. If Scotia grows then that should add to the return as well.
The table provided suggests which businesses investors value more. Often the market puts a premium on stability and growth. For example, telecoms, utilities, financials, and real estate tend to be mature business that provided regular and repeatable earnings.
LIMITATIONS
For the reasons above, it does make it a challenge to compare stocks in different industries. It is better to compare PE ratios within the same sector which can suggest over/under valued.
Furthermore, earnings can fluctuate wildly and may not provide the best buying indicator. For example, through the 2008 financial crisis many firms took write downs, laid off employees, provided severance, etc. This had an immediate negative affect to earnings and their respective PE ratios. However, it allowed many businesses to survive and, as the economy recovered, generate larger profits and consequently returns to investors.
A FINAL THOUGHT
Not all investing decisions can be broken down with one magic formula or ratio. You can’t just take a "paint by numbers" approach. Between 1975-2017, the MSCI World Value Index outperformed Growth Index by 2.1% a year. However, there are periods of time when Growth investors do better like the late 90s and today. Investors have been willing to pay premiums for tech companies that appear to be taking over the world.
PEs can also be a quick guide to compare various geographical markets. The chart below suggests the US market demands a premium or could be over-valued:
Being a successful investor takes discipline and diversification. We continue to encourage investing globally into diversified markets. Canada as measured by the S&P/TSX is 75% banks and resources stocks. In addition, Growth companies are trading at the largest premium to Value since the early 2000s. At some point this will likely change and I believe value investors will be rewarded again.
Until next time…Invest Well. Live Well.
This document was prepared by Eric Davis, vice-president, portfolio manager and investment advisor, and Keith Davis, investment advisor, for informational purposes only and is subject to change. The contents of this document are not endorsed by TD Wealth Private Investment Advice, a division of TD Waterhouse Canada Inc.-Member of the Canadian Investor Protection Fund. All insurance products and services are offered by life licensed advisors of TD Waterhouse Insurance Services Inc., a member of TD Bank Group. For more information, call 250-314-5124 or email Keith.davis@td.com.
