Are S'pore tech PEs on the high side?

With the price-earnings (PE) ratios of local technology counters as high as 89 times earnings, some investors are starting to wonder whether they're paying top dollar for their companies.

With the price-earnings (PE) ratios of local technology counters as high as 89 times earnings, some investors are starting to wonder whether they're paying top dollar for their companies.

Unfortunately, investors tend to spend more time talking about PE ratios than they do thinking about it.

Most know that the PE ratio is a value measure. Mathematically speaking, the PE ratio is a pretty simple concept. "P" is the price per share, and "E" is the earnings per share. Thus, the PE is computed by dividing the share price by the EPS (earnings per share).

For example: If Datacraft Asia's share price were US$6.25, and its EPS (for the year ending 30 June 2000) were US$0.07, then Datacraft's PE would be 89 times current earnings (US$6.25/.07). But what does this mean?

• A primer on PE
• Compare before you buy
• Ratios of Ratios

The writer is CEO of Asia-centric personal finance site WallStraits.com. A primer on PE

PE is assumed to be a key value measure. In the simplest terms, the PE tells you how many years it will take for your investment to "earn back its cost". Put another way, given its current earnings, it will take 89 years for Datacraft to earn enough profit to pay shareholders back the cost of the share today. (Wait a minute, did somebody say 89 years!)

However, PE is not so simple as it first appears.

The reason why investors are willing to pay 89 times current earnings for a share of Datacraft Asia is because they predict its earnings will grow quickly.

Indeed, Datacraft has, over the last several years, been able to grow its earnings by more than 40 percent per year, which changes our calculation of payback.

Datacraft, at a 40 percent growth rate on an EPS of US$0.07 last year would be US$0.098 (US$0.07*1.4) this year, US$0.137 (US$0.098*1.4) next year, US$0.192 (US$0.137*1.4) in 2002...and all of a sudden an investor "gains" back his original investment in just 10 years instead of 89 years (the sum of earnings for the 10 years is about US$6.84. For simplicity's sake, we ignored the risk-free rate, which are quite low at the moment anyway).

Here's what that will mean to your share price each year, assuming an earnings growth rate of 40 percent and PE of 89...

   • 2000: Datacraft @ US$6.25/share earning US$0.098, PE 89.
   • 2001: Datacraft @ US$8.72/share earning US$0.137, PE 89.
   • 2002: Datacraft @ US$17.09/share earning US$0.192, PE 89.
   • 2003: Datacraft @ US$23.94/share earning US$0.269, PE 89.
   • 2004: Datacraft @ US$33.46/share earning US$0.376, PE 89.
   • 2005: Datacraft @ US$46.90/share earning US$0.527, PE 89.
   • 2006: Datacraft @ US$65.68/share earning US$0.738, PE 89.

Growth is everything!

That patient investor who vastly "overpays" for a Datacraft share today and waits 10 years to recoup his value in profits--assuming the same growth rate--would find that in just three more years (13 years from today), his stock would be earning the original purchase price in a single year; and in another three years (16 years from today), twice the original investment in a single year.

This is an effect called compounding, the magic phenomenon that makes long term stock investors the wealthiest and happiest people on earth.

Sure, I know what you're thinking...10 to 16 years is still a long time to wait! Well, stay calm. If Datacraft keeps on growing profits at 40 percent a year, you won't have to wait 10 years to get ahead. You see, as investors are likely to have a difficult time finding companies that can grow so fast, Datacraft will probably maintain their lofty PE of 89 each year. This is because profits can be made from price appreciation, assuming the PE is maintained, and not just from "earning back" profits to match the initial investment.

Say you just can't wait more than 5 years, and you want to bail out in year 2005. You'd pocket a nice S$47 per share, or a 650 percent profit. The PE says you have to wait another 5 years to "earn" back your original investment, but the market says otherwise.

Some investors may argue that the risk of investing would be lower for a stock with a lower PE and lower growth rate, but it's also important to realize that, theoretically at least, a stock demands a lower PE because of its slower growth.

Hence, Datacraft should maintain its lofty PE as long as growth is expected to continue, as indeed it has for many years despite the regional economic crisis. Why argue against the market? In the meantime, it's possible for investors to benefit from price appreciation even before the 10 years are up.

That said…investing in high-growth companies with lofty PEs is not a low-risk strategy.

Now, here's a perplexing question: "Was Datacraft expensive back in year 2000 at US$6.25/share and a PE of 89?" Your view from today, and your view from 2005 may lead you to dramatically different conclusions.

• Are S'pore tech PEs on the high side?
• Compare before you buy
• Ratios of Ratios
Compare before you buy

PE by itself is still not a lot of information for an investor to go on.

Many professional stock analysts will group together companies in a similar industry and compare their PE ratios to get an idea of which are "expensive" or "cheap" compared to their peers.

For example, here's a table to compare the PE ratios of some of the major contract manufacturers in Singapore:

Singapore Contract Manufacturers:

Company Market Cap Share Price Historical PE
Venture Mfg S$3.5 billion S$15.00 37.3
Natsteel Elec S$1.4 billion S$3.15 15.7
JIT Holdings S$925 million S$3.75 33.6
Omni Industries S$900 million S$2.30 29.9
GES International S$665 million S$1.25 24.7
Natsteel Broadway S$344 million S$1.70 8.0
Ionics Corp S$250 million S$0.40 13.3
Jurong Tech S$80 million S$0.21 14.2
CEI S$50 million S$0.27 19.2

Source: Wallstraits.com Pte Ltd. As of October 16, 2000.

A quick scan through the list shows the companies that investors believe have the most potential for growth. After all, paying a higher PE indicates a willingness to pay for the company's future cash flow and earnings, especially if you believe its earnings and cash flow will grow at a higher rate than that of its peers.

In this case, investors appear to believe that Venture Manufacturing will produce the best future growth in the outsourced electronics manufacturing industry, and NatSteel Broadway, the least.

One investor could look at this list and conclude that Venture Manufacturing is the premium "class act" among its peers, a true leader in the industry validated by dominant market capitalization and high PE. Another, perhaps equally intelligent, investor will see the very same list and conclude that NatSteel Broadway is the best bargain, validated by the single-digit PE only one-fourth the multiple of the peer-group leaders.

So, maybe we need still more information…

• Are S'pore tech PEs on the high side?
• A primer on PE
• Ratios of Ratios
Ratios of ratios

If one ratio can't answer all your questions, perhaps you need to explore slightly more complex ratios of ratios, such as a PEG ratio.

The PEG offers a way for investors to look at PE in relation to earnings growth rates. At its simplest, it is computed by first calculating the PE, and then dividing the PE by the rate of earnings growth. Here's the same list of contract manufacturers with a comparison of PE, earnings growth rates and PEG ratios.

PEG for Singapore Contract Manufacturers

Company PE Ratio Pre-tax Profit Growth PEG
Venture Mfg 37.3 +0.4% 93
Natsteel Elec 15.7 -45% ---
JIT Holdings 33.6 +25% 1.3
Omni Industries 29.9 +75% 0.4
GES International 24.7 +42% 0.6
Natsteel Broadway 8.0 +19% 0.4
Ionics Corp 13.3 +39% 0.3
Jurong Tech 14.2 -4% ---
CEI 19.2 +118% 0.2

Source: Wallstraits.com Pte Ltd. As of October 16, 2000.

Obviously, the lower the PEG the stronger the value presented by the company in terms of PE and earnings growth rates. All of a sudden, Venture Manufacturing looks like a very expensive stock with a PEG of 93!

Most value investors look for a PEG of 0.5 or lower as an indicator of screaming-bargain-basement prices. With the currently depressed tech sentiment in the market, our list of contract manufacturers offers several such bargain PEG stocks, including CEI, Ionics EMS, NatSteel Broadway and Omni Industries. Of these PEG values, Omni Industries boasts the highest pre-tax earnings growth rate at a scorching 75 percent!

The most thorough investors will want to take one more step (at least) and look at the average earnings growth rates over the last three consecutive years, just in case the most recent earnings report were not consistent with the overall historical trends. In fact, such is the case with Venture Manufacturing, as their average pre-tax earnings growth rate over the last three years is better than 30 percent.

Investors may also want answers to less quantitative and more qualitative questions such as which electronic manufacturing services (EMS) firm has the highest profit margins; what percentage of each EMS firm's sales are in hot areas like Internet infrastructure equipment and communications devices and personal digital assistants (PDA); which EMS firm has long-term contracts with global leaders like Cisco, IBM and Dell; and which EMS firms have historically been able to manage their cash most efficiently (as this is a very capital intensive industry).

The answers to these more quantitative questions may help explain why Venture Manufacturing may be considered the cream of the EMS crop.

So, are Singapore's contract manufacturers' PE ratios on the high side?

The answer will depend on the investor's investment time frame, goals and expectations of the company's future growth. Different investors may have a different view of what "value" is with respect to their unique needs.

Note, however, that all should be wary of taking the PE as an end-all value measure--hindsight can easily make fools of all of us.

• Are S'pore tech PEs on the high side?
• A primer on PE
• Compare before you buy