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Guarding Wealth: Buying risk, paying for liquidity

Price-earnings ratios are a useful way to analyze your investment decisions

Guarding Wealth: Buying risk, paying for liquidity

What do you get when you invest in capital markets? You might say stocks or bonds, mutual funds or units in real estate investment trusts. That answer is both true and false. You do get ownership of those things, but in a more analytical sense, what you are really getting is risk — any stock or negotiable bond can vary in price, and illiquidity, for stocks and bonds must be sold to be spendable. Both are proportional to return. In general, the higher the risk, the higher the expected payoff (or loss). The easier it is to cash out, that is, the higher the liquidity, the lower should be the expected return.

Stocks do produce cash, either as earnings and dividends. Bonds generate interest and, if they can be traded after purchase, which is the case for all negotiable bonds, they can generate capital gains or losses.

Let’s examine stock risk first. The risk in holding in any stock is immense. As a shareholder, your money is backed by no company promise other than to let you vote for directors. With non-voting common stock, you don’t even have that.

Price-earnings ratios

There are several measures of stock risk. One of the best is the widely used and very common ratio of price to earnings. Price earnings ratios express shareholders’ expectations for the stock. A low p/e ratio, say below 10, implies that earnings are expected to be flat or to rise little. While a dead in the water stock may have a high p/e ratio if investors wait for the company to be sold and reward them with a handsome takeover premium, p/e remains a good first guide to expectation for a stock.

Stocks vary in their risk. There are several measures of how risky a stock is. A common one, called beta, just reflects how volatile or bouncy a stock is in comparison to the entire market. A beta of 1.0 means the stock is as volatile as the market. A beta less than 1.0 means the stock is less volatile than the market, a beta of more than 1.0 means the stock is more volatile than its broad market. For example, Royal Bank’s p/e on trailing earnings, that is earnings per share reported for the last 12 months, is 13; Bank of Montreal’s is 12; CIBC’s is 12.4. P/e’s for expected earnings tend to be a little lower, for the earnings are expected to be higher. But whether you are looking at past or future earnings, the real meaning of the p/e ratio is how long you have to wait for earnings at the present rate to pay back your investment. Of course, if the stock pays a good dividend, that will cut your payback period.

When p/e’s rise into the 20s and 30s, the price of the underlying stock is considered to be driven by high growth expectations. Thus it is a so-called growth stock. In this category are smaller firms that can generate high growth. For example, Gildan Activewear, a maker of t-shirts and other athletic apparel, has a p/e of 20, reflecting investors’ expectations that it will be able to keep its sales rising. Dollarama Inc. has a p/e of 27. So far, neither Gildan nor Dollarama has disappointed shareholders who have stuck with the shares through their occasional down times.

Back in the dot com bonanza, 1998 to 2000, companies sometimes got p/e’s over 100. One firm, now out of business, had a p/e of 800. Investors threw money at these stocks on the theory that they had to be hot, otherwise they could not have such p/e multiples. These were momentum stocks, propelled upward by investors because they saw other investors hopping on the bandwagon. For such multiples to be rewarded by actual earnings, earnings would have had to grow at 60 per cent a year compounded annually. A few companies have such gains, but there are none able to sustain such growth for a decade. The dot coms crashed, taking down the fortunes of investors who had ignored traditional multiples.

An investor looking at p/e’s alone should stick to the low double digits. Indeed, that’s where the chartered banks are. In the low 20s range, you find Canadian National Railway at 20.9. CP has a p/e of 36.9. The p/e difference is huge, but CP is undergoing a transformation under former CN boss Hunter Harrison. He has forced the railroad to morph from the worst performer in North American railroading to one of the best. In the last quarter, earnings were up over the same quarter a year earlier. Harrison has agreed to stay on the job to 2017. The higher multiple for CP appears to be warranted, say shareholders (of whom I am one).

P/e’s can be high even if there is not a lot of expected growth. For example BCE Inc., the phone company, has a p/e of 19.6 based on last year’s earnings. Odds are that the company’s earnings from wireline phones, cell phones and publishing are not going to increase at a rate high enough to justify this multiple. But bond interest rates are low, virtually forcing money into relatively stable stocks and BCE is seen by many as a kind of bond with almost bulletproof earnings. They are treating BCE as a quasi-bond and propelling it into growth stock territory. Chances are that if and when interest rates rise appreciably, money will come out of BCE stock. Perhaps earnings will have risen enough to cushion the fall. This is what equity risk is all about. Unlike bonds and their promise to pay, stocks are balanced between expectations and realizations. That is not a lot different than shooting craps in Vegas, though, to be sure, some stocks are safer bets than others.

P/e is not the whole story. It expresses valuation, but that alone does not tell an investor the complete tale of an asset’s risk. For that, you have to add what you are putting into the stock. P/e multiplied by your investment tells you what you have at stake in the stock. So if earnings are $5 a share and you pay a p/e of five, you have $25 at stake as a bet on earnings. If the p/e rises to 10, you have to pay $50 for those earnings. At 30, you are paying $150 as a bet on what the company will report in a year. If it turns out that earnings are flat, you will have to wait three decades or a little less if there are dividends for earnings to repay your investment.

Other measures

There are many other measures of what a company is worth. Price to sales is a good valuation, for sales are solid and reportable and can’t be manipulated like earnings. For example, a company can accelerate some costs, charge them against earnings to get them out of the way, then show a glowing next quarter with lower costs and higher resulting earnings. Or it can recognize some earnings ahead of when they are realized. That can be done by recording sales when goods or services are shipped rather than paid. If receivables rise faster than sales, then you know that either the company is playing tricks with its books or that customers have good reasons not to pay.

If you want to learn more about how this works, get a copy of Abe Briloff’s More Debits Than Credits: The Burnt Investor’s Guide to Financial Statements. It is a classic tale of deceptive accounting methods and how to detect them. Read it and you will be at least alert to what crooked accounting and limp stock analytics can do to trusting investors.

About the author


Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.



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