Using the price earnings ratio to pick ASX winners and losers

When it comes to sharemarket investing, one size never fits all. If investing was as easy as looking at a low P/E ratio, we'd all be millionaires.

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When it comes to sharemarket investing, one size never fits all. If investing was as easy as looking at a low P/E ratio, we'd all be millionaires, writes The Motley Fool.

The Price Earnings Ratio (P/E Ratio) is calculated by dividing the current share price with the net profit per share. It is a commonly used measure of value.  Conceptually, it gives an indication of the number of years it would take for net profit to "cover" the price paid for the share, assuming the same net profit is earned every year, and assuming no further shares are issued.

Historical P/E ratio refers to a P/E Ratio calculated by using the last annual net profit figures. Prospective P/E ratio refers to a P/E Ratio calculated using forecasted net profit figures for the coming year. We will be referring to historical P/E ratios unless specifically stated otherwise. Also, the term net profit and earnings are used interchangeably.

Generally speaking, a low P/E ratio provides a good starting point for further investigation of whether a share is attractively priced as an investment. However, in investing, one size never fits all, and the surest way to financial doom is to use only one investment measure for all decisions, and that includes slavishly buying shares with low P/E ratios.

Net profit versus cashflow
Firstly, we must understand that net profit is an accounting construct. There is vast literature on this subject. For now, we just need to know that accounting earnings sometimes do not reflect the true economic performance of a business. It is prudent to check whether net profits match operating cashflow.  This means that an investor checks, preferably over a number of years, whether the stated net profits match operating cashflows of the business.

Extreme caution is recommended when net profits are high but operating cashflow is negative over several years. As an example, Timbercorp Limited had a P/E ratio of 4 but was massively cashflow negative, which led to its demise shortly thereafter. Mortgage Choice Limited (ASX: MOC) is an interesting situation where the P/E ratio is 5.5, but the operating cashflow is only half of the net profits. What appears cheap at first sight may not be such a bargain after all.

Low ROE and no dividends
A company with low return on equity or low return of capital is destroying value for shareholders. Basically, if a business cannot even generate a better return than the 6% savings rate, then the business has no reason to hold onto its capital, and shareholders would be better served if the business is liquidated and all money returned to shareholders.

With these kinds of businesses, a low P/E ratio is of no help, as every dollar reinvested into the business will generate less than one dollar of value for shareholders. More often than not, these businesses are capital intensive, and if an abnormally high dividend is paid, the competitive position of the business will often be eroded. You need to go no further than to look at Qantas Limited (ASX: QAN). Do you want more dividends or safer newer planes?

Abnormals, and revaluations
A lower P/E ratio can be generated due to once-off abnormal earnings. Investors should focus on operating earnings, which is earnings generated from the core business.

A recent example is the ANZ Banking Group Limited (ASX: ANZ) whose results were boosted by $500m less in provision for bad debts. Another example is United Overseas Australia Ltd (ASX: UOS) where profits are generated from a revaluation of properties every year, therefore the abnormally low P/E ratio is not an indication of the performance of its core business, although UOS is attractive from an asset valuation basis.

Conversely, a P/E ratio may be abnormally high due to write-offs which are non-recurring.  Recent examples include Flight Centre Limited (ASX:FLT) and JB Hi-Fi Limited (ASX: JBH). If we strip out the effect of these abnormal write-offs, we ended up with very attractive valuations, especially in August this year.

Lastly, there is a saying that if it happens more than once, an abnormal becomes normal. Investors should be careful of companies making write-offs on a constant basis.  This indicates bad acquisitions in the past, and may be an indication going forward if the same management team is involved. Structural Systems Limited (ASX: STS) appears to exhibit signs of these problems.

Cyclicals and Earnings Deflation
Investors should also be careful of companies operating in cyclical industries. The low P/E may indicate peak earnings. That points to most of the resources companies on the ASX at this moment, although we believe BHP Billiton Limited (ASX: BHP) to be the exception due to the size, class, cost base and diversity of its assets.

Low P/E ratios may also be an indication that earnings will be decreasing.  A P/E 5 becomes PE 10 if net profits dropped by 50 per cent. This relates to the issue of picking good businesses with sustainable earnings.

High Debt
Lastly, avoid companies with high debt, even if the P/E is attractive, unless the cashflow is both sustainable and sufficient to cover immediate debt requirements and covenants. AMA Group Limited (ASX: AMA) provides a good study of what to watch out for.

If you are looking for investing ideas, request our free report, The Motley Fool's Top Stock For 2011-12. Click here, whilst it's still free and available.

Fool contributor Peter Phan owns shares in AMA and UOS. The Motley Fool's disclosure policy is more than one-dimensional. The Motley Fool's purpose is to educate, amuse and enrich investors. This article has been authorised by Bruce Jackson.

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