Forum Archive Index - November 2003

[mixtrader <mixtrader@clear.net.nz>]

An interesting discussion

I take a slightly different approach in terms of definition

A share's value is really the sum of two parts - the value of the assets in
place, and the present value of growth opportunities (ie future
opportunities of the firm to invest in high-return projects).  The
Price-Earnings (P/E) ratio reflects the market's assessment of the growth
opportunities.

One of the problems I see is in obtaining a good assessment of the firm's
earnings - reported earnings are based on generally accepted accounting
principles (GAAP) which calculate depreciation based on IRD "rules of thumb"
rather than true rates of depreciation.  Also, methods of valuation of the
firms assets (in particular inventories, but also fixed assets, brands and
goodwill) and the treatment of certain classes of expenditure (capitalised
and depreciated, or fully expensed over current year) can impact on reported
earnings.  The revaluation of assets can be particularly distortionary to
reported earnings.

I don't think there is a simple answer to arriving at either a "true"
assessment of the value of growth opportunities, or a "true" assessment of
the firms earnings and as such I tend to view P/E ratios as benchmarks
rather than absolute numbers.  I generally tend to avoid stocks with high
P/E ratios on the basis that the market appears to be paying a lot for the
earnings potential of those firms and that generally mid range P/E (say 11 -
16) ratio firms are earning the share price back quicker.

Maybe it's because I am only a little fella that I keep remembering the old
school yard jingle - "the bigger they are, the harder they fall" and
translate it to "the higher they are, the further they fall".

----- Original Message ----- 
From: <tennyson@caverock.net.nz>
To: <sharechat@sharechat.co.nz>
Sent: Sunday, November 02, 2003 7:22 PM
Subject: Re: [sharechat] AIA reply to snoopy by macdunk


> Hi Macdunk,
>
> >
> >Sorry to contradict you snoopy
> >
>
> Hey, don't apologise, go right ahead :-).   This is one of the things that
> makes this forum interesting.  People with differing views.
>
> >
> >but you are missing a few very
> >important points In the macdunk strategy. Lets take one of your
> shares
> >WRI for Instance.   I will round the numbers slightly to keep the
> >mathematics understandable. Todays price = $1.50    PE 10.94  Yld
> >11.44.   That Is todays numbers the point you miss Is lets say you
> >bought them four years ago at 75c which means that your PE Is half,
> >and your yield double relative to what to today's figures show.
> >
>
> I take your point.   However, WRI is a little different from AIA.  WRI
> was a real market dog at one point.  AIA has never been that.   WRI is
> on a P/E of 11.  AIA is on a  P/E of 26.   That amounts to a big
> difference in the earnings expectations of each share.
>
> Nevertheless if you look at the WRI numbers you have provided in
> isolation, they illustrate your point.  It is another way of looking at
the
> compounding effect of earnings over time.
>
> One of Warren Buffett's most often repeated quotes is that:
>
> "It is far better to buy a wonderful company at a fair price , than a fair
> company at a wonderful price."
>
> The question I am asking you is not
> "Is AIA a wonderful company?" (the answer to that is 'yes', no doubt
> about it).
> The question is,
> "Is $6.60 a fair price for AIA, given the upside risk and the downside
> risk?"
>
> >
> >In my original post I likened It to buying a house.    I stated that
> >It Is better to pay slightly more than what It Is worth today to get
> >what you want, because next year the price Is right, and the year
> >after you have a bargain.
> >
>
> Yes, except that house prices do not go up evenly every year.  House
> prices could be flat for five years.   In that scenario, having your money
> in a house is a lost opportunity cost.
>
> >
> >Lets keep AIA figures confined to
> >2003 and do some more sums.    On the 15th of Jan 2003 aia was
> $5.46
> >today they are $6 61 with a PE of 26.66 and a yld of 4.97 but hey If I
> >bought In Jan at $5.46 I must recalculate My PE Is lower and my yld
> >higher.  My strategy Is to find companies that are Increasing their
> >earning potential, and dump the ones that have ended their run.
> >
>
> I think your strategy is fundamentally sound.   However, I see a couple
> of hooks in the execution of it.  Remember when the WRI earnings fell
> thios year, yet the share price still went up?    Well the reverse effect
is
> possible too.   AIA earnings might go up, but the share price could fall.
>
> The hook I see in your strategy is that if the AIA share price was $4 or
> $10 at the start of the year your startegy wouldn't change.    Because
> AIA is on a 'growth path' you would buy in regardless of the share
> price.   Regardless of how well the underlying business is actually
> doing, you seem to regard $4, $5.40 or $10 as equally valid entry
> prices as long as an uptrend in business outlook is intact.
>
> Yet it is obvious to me that buying in at $4 would be far less risky than
> buying in at $5.40.  You claim you will be able to 'get out' at any sign
of
> trouble.  But in my experience high P/E shares can fall very hard very
> fast.
>
> I suspect that because of all the new airlines coming into Auckland a
> PE of around 26 can be justified for now, given the outlook for the
> coming year.   However, I don't think you have explained why a P/E of
> 26 can be justified in FY2005 when the historic average PE for this
> share is 'only' around 20.
>
>
> >
> >You are right In one respect,
> >  This share wont grow at 20pc pa forever, but
> > for the moment and the next couple of years It will.
> >
>
> That is a statement of faith.  Actual earnings per share have risen
> 2.6%, 2.5%, 21.1%, 15.4%, 20.3% and 30% since the company was
> made public.  But these earnings incorporate two rounds of significant
> property valuations.
>
> The only way I can see your prediction coming true is if further
> significant property revaluations happen in the next two years.
>
> An AIA share price of $8 in a years time would mean the company is
> priced to perfection.  I'm not saying it can't happen.   But I would be
> balancing the risk of that against the risk that the share price could
> revert to an historic mean PEof 20.   Such a reversion would see the
> share price fall to around $5 with no change in earnings.   I'm not
> saying that this will happen. I am saying that the potential for gains do
> not outweigh the potential losses in my eyes.
>
> Of couse if my entry price was $5.40 then a share price plunge to $5
> would not faze me too much.    I am sure that most long term holders of
> AIA would be happy to hold at those prices.   But buying in today at
> $6.60 is another matter.
>
> >
> >The PE means
> >nothing to me or the yield all I look for Is a well run company that
> >is Increasing Its profits at a faster than normal rate
> >
>
> A P/E of 26 is not just a number.  A P/E of 26 does mean:
> "a well run company that is increasing its profits at a faster than normal
> rate."
>
> >
> >  All calculations must be done at the buy In price,
> >
>
> I agree.   But there is a significant difference between a buy price of
> $5.40 and $6.60.
>
> SNOOPY
>
> discl: no AIA shares held
>
>
> --
> Message sent by Snoopy
> on Pegasus Mail version 4.02
> ----------------------------------
> "You can tell me I'm wrong twice,
> but that still only makes me wrong once."
>
>
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