Why the Leading P/E Ratio Makes Sense

PERSONAL FINANCE 101

Wrong PE?

In a post at the beginning of the year, we discussed the price-earnings or P/E ratio in detail, particularly how we can use it to distinguish between undervalued stocks (which we would want to buy) and overvalued stocks (which we would want to sell or not buy). In that post, we also took a brief look at the leading P/E ratio, which is based on the forecast earnings for the following year.

leading P/E ratio = P0 / E1

Where P0 is today's stock price, and E1 is the earnings per share next period.

While using E1 seems to make sense since it accounts for future earnings, using just one earnings forecast may not be able to completely capture the future profitability of the firm/stock.

But as it turns out, it can.

There are different ways of estimating the intrinsic value or "true worth" of a share of stock. I'll get into the basics of stock valuation in a future post, but for now just remember this:

The intrinsic value of a share of stock (or any asset) is the present value of all cash flows it can generate in the future.

Based on this idea, we get one of the simplest models of stock valuation: the Gordon or Dividend Growth Model. This model, which was named after Highly-Regarded Economist and Distinguished Senator, Dick Gordon (Kidding! Just checking if you are still paying attention ;)), makes the following assumptions:

1. Dividends grow at a constant rate, g
2. The investor's required rate of return, k, is greater than g and is also constant (per stock)
3. The investor holds the stock forever

By the magic of math, and given the above assumptions, we can compute for the stock price with

P0 = D1 / (k - g)

If we divide both sides of the equation by E1, we get

P0 / E1 = (D1/E1) / (k - g) = leading P/E ratio

D1/E1 is the portion of the firm's earnings next year that it will pay out as dividends, or the firm's dividend payout ratio for next year.

Now here's the interesting part. As it turns out, firms typically have constant dividend payout ratios, making D1/E1 easy to estimate (by using the latest payout ratio, for example). So given D1/E1, and estimates for k and g, we can compute for the leading P/E ratio. Since the leading P/E ratio is based these "fundamental" inputs, it is also referred to as the fundamental or justified P/E.

The leading P/E computed using the above approach gives us what the P/E of a stock should be, and we can compare it to other P/E estimates (using the current stock price and forecast earnings, for example). If the forecast P/E is greater than the one using the fundamental approach, then the stock may be too expensive, and cheap if it's the other way around.

But how can we estimate the inputs required by the model? This I will discuss next week. Have a great weekend everyone!

Short Answers to Unanswered Questions: Stock Delisting, Pulling Out of a VUL, and Non-Monetary Returns

DEAR INVESTOR JUAN

Dear Investor Juan,

I am an avid reader of your posts and have just started investing 3 months ago. I currently have invested mostly on fixed income peso denominated notes as they I am not yet confident in my skill with stocks. From my readings on your post however I have not come across delisting of stock (maybe I have not read enough) from the PSE:

a. What happens to the stock?
b. Encashment after delisting?
c. Will the price still have a chance to go up?
d. Other concerns an investor should think before purchasing a stock which is going or planning to be delisted?

Sincerely,
Mike


Dear Mike,

Thanks for the question, it's a very good one. There are both negative and positive reasons for "delisting" from the stock exchange--making a stock unavailable for public trading. The "top-of-mind" reason, most probably, is if the company gets into trouble financially, such as if it is forced to go declare bankruptcy. In this case, investors should be able to get early warning from sharp and sustained declines in stock price, public disclosures, and even news reports, although losses may be unavoidable.

In some instances, though, a firm may have very good reasons to delist and revert to being "private," In this case, the firm buys back shares traded in the stock exchange, and public investors would receive a tender offer for their holdings.

In summary, and to address some of your issues regarding the possibility that a stock you own would delist, if it's because of the first reason then you should actually be concerned about whether the firm is capable of sustainable profitability rather than the possibility of delisting. And if the firm chooses to delist because of the second reason, then there's really no reason to worry because you should get at least the market value of your investment (more if the firm has reason to pay a premium for publicly-held shares) if it happens.


***

Dear Investor Juan,

I have started investing some of my savings in SunLife VUL (Equity Bond) since Nov 2007.
And i have started investing in BPI's UITF products, some in ODYSSEY PESO BOND FUND and a little in ODYSSEY PESO CASH MGT FUND, about a year now. I read one of your article or comments about ODYSSEY and about VULs, and it seems its not a good one, should I redeem my investment and invest it somewhere else?

In your own opinion, don't worry I will not blame you in case anything goes wrong, where should I put these investments? Should I just hold it there, and just make new investment. I want to make sure that I am investing correctly.

Thanks,
Aubrey


Dear Aubrey,

According to the "search" function of this blog (a feature everyone would do well to learn to use), I've only talked about Odyssey funds only once, and even then I did not talk about either the Odyssey Peso Bond Fund or Peso Cash Management Fund. After consulting Bloomberg, I see that these funds charge management fees of 1% and 0.75%, respectively, which are comparable to similar products in the market (at least there's no front or back sales load). Just based on this, I have no reason to recommend that you pull out of these funds.

Regarding your VUL... As far as I know another important "cost" of VULs (apart from higher fees) is the cost of getting out of the agreement early. So I suggest that you first contact your agent and ask if you can terminate the coverage and recover the portion of your premium payments that was allocated to the mutual fund, then get back to me with your agent's answer.


***


Dear Investor Juan,

Greetings from Dubai!

Are you having an income directly by posting articles in your blog?

Regards,

Marlo
Accountant



Dear Marlo,

No, I don't. As a matter of fact, I even spend a small amount periodically for extra cloud storage (which is shared among all my Google accounts and websites, actually) and domain name registration. But that does not mean I don't get anything out of what I do.

This blog is very rewarding to me, albeit in a non-monetary sense. First, writing something regularly (~9 times a month!) serves as good practice for writing my dissertation and other "official" writing assignments. Second, this blog gives me an opportunity to not only share what little I know about finance but also learn from the collective experiences of all you readers. And it forces me to learn about things that I don't know, or know very little about, and that's a very good thing. Finally, managing the blog, organizing and processing ideas about personal finance, helps me better manage my own finances to. Haha, so yeah, maybe the blog does offer monetary rewards, if only indirectly.

Arithmetic Mean: The Return of the Comback

PERSONAL FINANCE 101

Some of you may remember how, in a previous post, I have relegated the arithmetic mean--more popularly known as "average"--to irrelevance. In the example that I used, we saw how the geometric mean is the more appropriate measure of investment performance since it accounts for compounding every period.

I have recently realized, however, that the arithmetic mean is not as inutile as I first thought. How exactly? Please refer to this series of returns earned by a mutual fund in the past 5 years.

Year 1 = 10%
Year 2 = 4%
Year 3 = -7%
Year 4 = 15%
Year 5 = 11%

The arithmetic mean of these returns is 6.60%, while the geometric mean is 6.31% (do you still remember how to compute for these?). Nothing has changed: the geometric mean is still the appropriate measure of investment performance, meaning that if you invested in the fund at the beginning of Year 1 (and reinvested all income/earnings), your investment will have grown by 6.31% per year and not by 6.6%.

So what is the arithmetic mean for? If we want to predict or forecast how much the mutual fund in our example will earn the following year (Year 6) and assuming that the returns in the past five years are equally likely (meaning the probability that the fund will earn 10% or 4% or -7% or 15% or 11% is the same), then we should use the arithmetic mean. In this case, the simple average gives us the expected return for the following year. In the example, we can therefore say that on any given year, using past performance as basis, the fund will earn 6.6% on average.

So remember, if your want to measure the performance of a multi-period investment on an annual, compounded basis, use geometric mean. But if you want to forecast the return for one period using historical data, the arithmetic mean is more appropriate.


***

PS. I apologize to those of you who have sent me emails/questions for not being able to respond immediately. I've had a really busy quarter, but December will definitely be better, so I promise to answer all your questions soon, FIFO. :)

Pinoy (Pride) Pity

A GUEST POST by Anonymous

My boyfriend and I booked a biking tour when we visited Bangkok 2 weeks ago. Our first rest stop was at a park, leading to the “slums” – shanties put up under the bridge. Our tour guide Cha (pronounced Djaaa~, if you please), was quick to say, “The people who live here are not poor. There are no people in Thailand.”

I’m not sure what the Dutch and Danes in our party thought, but I was waiting for a punch line.

Here’s what followed instead: “The people who live here [in the slums] are not poor. They choose to live here so they won’t have to pay for rent, which means, they can send more money back home to their families. When you are poor, it means you have no food, no work. But anyone can get a job in Thailand. They can work as taxi drivers, truck drivers – anything. You will not see Thai people begging on the street. The beggars you see around are probably from Cambodia.”

That’s just all sorts of wrong, isn’t it? I certainly don’t believe there are no poor people in Thailand (You may open a new tab to Google the numbers). Those people who live in the shanties probably wouldn’t if they didn’t “have to”. But the stigma of begging – that was something to think about.

I personally think begging is obscene. This has nothing to do with those who beg, but having to resort to begging, is something I would never wish upon anyone. There is no shame in being poor, but there is shame in having to beg, and shame that you live in a world where your fellow has to beg from you.

I pity those who have to resort to begging. Pity, but nothing else. I sympathize with people for whom life is a burden. I respect people who ask for help. I admire people who are determined to help themselves. But I only feel pity for people who beg.

A beggarly attitude, though, is downright offensive. If you’re looking forward to Christmas as a time to receive dole outs from your wealthier relatives, it means you probably can’t afford Christmas. But if you intend to make the rounds bringing home made dinuguan, you have something to say for yourself (please stop by our house too – I beg of you!).

Here’s Emile Gaboriau, describing, Pascal Ferailleur, a young man in his crime novel, The Count’s Millions. Pascal’s widowed mother was cheated out of the millions earned by his late father, leaving them destitute:

“With a tact unusual for his age [a 12-year-old Pascal], or indeed at any other, he bore his misfortunes simply and proudly without any of the servile humility or sullen envy which so often accompanies poverty.”

-- The Count’s Millions

Lack of pride in oneself leads one to beg—for money, food, a savior, a miracle…Pride, not arrogance, is good. Pride is not false bravado nor is it stubbornness. Pride is not incompatible with humility. Pride means you believe you have something of value, even though you live in a shanty under a bridge. Pride means living in a shanty under a bridge, rather than begging. Pride can be found in being a truck driver, taxi driver—anything—but not in being a beggar. A laborer can look his employer in the eye and demand his pay. A beggar must accept what he can get.

If Cha is speaking for Thailand, it looks to me they’re aiming for the right thing—70,000,000 people who have confidence in themselves, and not 70,000,000 people who need to be saved.

The Philippines’ and Thailand’s numbers aren’t so disparate, yet I get the impression that we are perversely proud of being “poor” and welcome pity. We are quick to paint ourselves as long-suffering victims and are ready with a list of people to blame. But we lose interest in ideas for a solution – especially if it means we have to wait in line like everybody else, or if the solution isn’t as dramatic and sweeping as a lottery win.

If I’ve got it wrong, and this attitude reflects the refusal to put in work (and not about despair / confidence at all), then I guess we’re getting what we want. And we are very good at pitying ourselves.

Manuel Amalilio, Aman Futures Group, and the Great Pyramiding Heist of 2012

IN THE NEWS

If it seems too good to be true, then it must be.

This lesson was painfully and expensively realized by 15,000 Filipinos who unwittingly participated in a "pyramiding" investment scheme scam perpetrated by this guy:

Take a long, hard look at the face of Mr. Manuel Amalilio, Filipino Malaysian and CEO of Aman Futures Group Phils. Inc. According to reports, Amalilio is now out of the country, presumably with the 12 billion pesos that he allegedly bilked from his investors.

Online and traditional media are now rife with stories of how Aman's victims are now coping with the loss of a not-inconsiderable sum of money, in many instances from life savings, in some from high-interest loans from middling financial institutions. Reading these accounts and seeing the reports can be more than a little depressing. Situations like this are always very unfortunate, but much more so when many of the victims are the not-so-well-off.

While it's clear that blame and the plea for justice should be laid on the feet of Mr. Amalilio and his still unknown (or maybe just still unproven?) cohorts, we should all remember that we are not completely powerless to avoid falling into such a trap. Awareness, knowledge, and understanding of matters of money and finance--causes that are central to this blog--are key in weeding out scams like this from decisions and alternatives that truly provide additional value to people's lives.

And I think it's best if we make the most out of this atrocious situation and learn from the misfortune of others, however callous that may seem.

Short Answers to Unanswered Questions: Emergency Fund for Emergencies and Investing From Abroad

DEAR INVESTOR JUAN

Dear Investor Juan,

I'm Alexander, 23 y.o. I'm currently trying to create a sound financial plan for my accumulated savings. So far, i have roughly 150,000 in savings and i'll be setting aside 72,000 as an emergency/buffer fund (i pegged it at 6 months at Php 12,000 per month). The rest (at around 78k) i'm planning to put aside in high-yield investment instruments or maybe add it to the 7,000 i have in an equity fund which i opened last May. :)

Any advise where it's best to keep an emergency fund without exposing it to substantial risk but still guaranteeing sound returns? I checked BPI's Short term money market fund but it has this "Special Expense" quoted (Please see attached) which costs Php 2,000 p.a. I haven't checked with BPI yet but any idea if they charge it to you directly? (Php 2,000 is quite big of an expense!).

I currently have a maxi-saver account in BPI where i keep my emergency fund; it yields 2.250% gross interest p.a. (around 1.8% net after withholding tax) provided that no withdrawals are made within a month. the interest is also credited monthly so it's easy for me too keep track. but of course the 1.8% net yield is still quite low when you consider the annual inflation rate of around 3%. haha :)

With that i need your expert opinion on what is the best plan of action. i shall definitely consider it as an option in allocating my finances. Dealing with all the computations and options by myself is sometimes too taxing. :)

Thanks IJ.

Regards,
Alexander


Dear Alexander,

There's a saying, "You can't have you cake and eat it too." In finance, there's a similar saying, "There's no such thing as a free lunch."

Emergency funds are for emergencies, so they must be always readily available and liquid, and liquidity comes at a cost--lower returns. So I suggest to keep it simple and just park your emergency funds in a savings account. The extra return that you lose (~3% from a money market fund or time deposit minus ~1% from a savings account = 2% x 72,000 = 1,440 pesos per year) should be worth the extra liquidity and convenience that you gain.

If you want to invest in a money market fund, then by all means do so, but treat it for what it is--an investment in a low-risk, low-yield asset, and not an emergency fund.


***


Dear Investor Juan,

I just came your blog recently when was searching about UITF.

I just want to know your opinion on an idea that I'm contemplating. I'm in Australia and currently have a mortgage on a 3 bedroom unit I just acquire a year ago. I have about AUD 150K (PHP 6M) equity and with low interest rate at the moment (5%), I'm think of investing some of my equity in the Philippines in UITF/MF. I'm also looking at opening a Investment Manage Account in BDO or BPI. Do you think my idea is feasible? Will I likely earn more than 5% in the Philippines?

Kind regards,
Pinoy in OZ


Dear Pinoy in OZ,

What kind of investment gives you 5% a year in Australia? If that comes from fixed income securities or funds, you'll get the same of even a lower yield for the same kind of investment in the Philippines (the price we pay for a "better" investment climate). If that comes from equities, the local stock market has been able to provide more returns than that in the past couple of years (but understand that this does not guarantee that these high returns will persist in the foreseeable future). The point is, we can only compare returns of investments with the same risk, that is, fixed income to fixed income, equity to equity.

If you are keen on investing in Philippine securities, yes, you might want to consider getting investment/wealth management services. It's really a convenient way for Filipinos abroad to manage funds in the Philippines. I have just opened such an account, and will write about it this month. So stay tuned. :)

BPI Trade Set to Up Its Game

From the personal correspondence of reader Daniel with BPI Trade:


Dear BPI Securities Corporation Client,

Greetings from BPI Trade!

We are currently in the process of upgrading BPI Trade in order to provide a state-of-the-art integrated trading platform with the following capabilities:

- Robust system for executing and confirming customers' orders to ensure efficient order execution and accuracy.
- Complete process flow from order taking to settlement, so that you can conveniently pay for stock purchases and accept proceeds of sale as BPI Trade is linked to BPI ExpressOnline which allows direct access to your BPI Account.
- More tools in making well informed investment decisions such as historical charts and fundamental company and economic research.
- Modern portfolio management system to help you monitor and have better control over your equity investments.

BPI Securities Corporation


Market reports, finally!--this is something some readers were complaining about a while back.

But what's really exciting about this is the linkage with BPI ExpressOnline. It will make things significantly more convenient, particularly for us BPI account holders.

And I have to agree with Anonymous, this platform upgrade is well timed for the upcoming introduction of ETFs.

Would this be enough reason for you to stay with the platform, BPI Trade users? COL and other online broker clients, would this make you want to shift platforms?

For me, it's definitely a step in the right direction. Let's just wait and see--and cross our fingers--that they do it right.

Thanks for sharing this Daniel!

Short Answers to Unanswered Questions: Reinvesting Earnings, Money Market Funds, and Bond Bubbles

DEAR INVESTOR JUAN

Once again, it's time to catch up with some of your questions...


Dear Investor Juan,

Do you think it is a good strategy to sell units equivalent to the earnings of your original investment after a certain period of time lets say every 4 months? And re-invest on let say stocks?

Anthony


Dear Anthony,

The best way to reinvest earnings is to not redeem any of your units. "Cashing in" a portion of your investment and reinvesting the proceeds in stocks, as you suggested, would make better sense if you're originally invested in a non-equity fund such as a bond/fixed income or money market UITF and you want to diversify your portfolio. Reinvesting redemption proceeds into (more or less) the same kind of security may not make much difference in terms or risk and return to justify the additional transaction costs that you would incur, so maybe it would be better if you just keep your original investment intact.

***


Dear Investor Juan,

Good day!

Let me start by telling you how informative your blog is. I have a number of questions i want to ask you. I have recently invested a good amount of money in BDO's equity, Bond, Fixed-income and money market. The percentage of investments are as follows: 30%, 20% and 50 %. However i still have some money in the savings account. Should i put the remaining amount in a money market which would produce a better return than a Saving account?

I also invested money in foreign denominated funds. These being Dollar money market, Dollar bond fund, dollar medium term bond all at BDO. Moreoever, I have invested in the ALFM euro bond fund of BPI. My concern with this is the recent interest cuts by the Feds and ECB on interest rates have seen interest rates reach new lows. While this would mean that bond prices rise, at what point can the US and Europe sustain these borrowings until the burden becomes to heavy and a government defaults? Wouldnt this produce a bond bubble?

I also would like to ask how these Foreign denominated bond funds would fare in the long run considering that interest rates are set until 2014 in the US and in the foreseeable future for europe? lastly given that these Bond funds are mainly invested in ROP bonds would they be affected by the changing bond prices of the US and euro?

Hoping for your positive response.

Respectfully yours,

student


Dear student,

Wow, that's a lot of questions. Unfortunately, I don't have answers for some of them.

The returns that you get from money market funds is essentially the price of liquidity, of having ready access to cash that you get from a savings account. So sure, invest whatever amount you think you can afford to not be readily available in a money market fund, but remember that we all need to have some amount of cash at hand for various reasons.

If you were already investment in those fixed income funds that your mentioned before the rate cuts, then you should be happy because your portfolio value will already have risen, right?

Decreases in interest rates are a result of the injection of funds into the system by an economy's central bank (such as the Fed), and the central bank does this by buying securities such as bonds, not by selling them or borrowing money. So why would interest rate cuts result in a heavier debt burden for governments? Unless I'm missing something here...

Bubbles are created by unrealizeable/unjustifiable expectations, and bond price bubbles occur when investors bid up the price of bonds to a point where it can't be justified by interest rate cuts. Whether the current rise in bond prices represent a bubble or not is a matter of opinion, though. By the way, the cuts already happened, and prices have already risen, so you should be more concerned if what we have now is a bubble rather than if a bubble will be created.

Finally, I'm afraid I can't answer your last set of questions because I have no idea how foreign exchange rates will move in the future.

I hope that my responses are positive enough, as you hoped.

Broke

Would you rather have their problems?