Wednesday, November 4, 2009

Don't Be Fooled By High P/E Values

As the market has risen throughout most of this year, many market observers have noted that P/E values are looking rather inflated from a historical standpoint. But of course, earnings are lower than usual this year due to reduced revenue that was caused by financial shocks. So as investors, should we be willing to pay a higher P/E for now, on the assumption that earnings will soon pick up?

When considering the market in the aggregate, this is a very difficult question to answer. Some companies will have cost structures that prove too rigid, and will therefore be unable to adapt to a lower revenue environment. Other companies, on the other hand, will have flexible cost structures or will see revenue continue to grow, despite the downturn. But to determine which of these forces will exert more pull on the market's earnings in the coming quarters is not only extremely difficult, but unnecessary: unless you're trying to value the entire index, you don't have to answer this question for the market in the aggregate. Instead, you can try to answer this question for individual securities, which are much easier to understand.

For example, consider Key Tronic (KTCC), a manufacturer of electronic devices. The company has a P/E of 23, which makes it appear overvalued. But earnings are down because year-over-year quarterly revenue is down 15%. However, the company has little in the way of debt, and has the vast majority of its operating leases coming due in the near-term, giving it further flexibility in reducing its costs. Operating expenses are down 17% this year, and the company sees sales starting to rebound in January of 2010. In fact, based on KTCC's past margins and returns on assets (which it should be able to return to by continuing to cut costs and with a modest recovery in revenues in the years to come), it appears to trade at a normalized P/E much, much lower than the 23 that stock screeners currently display. (KTCC is a stock we've previously discussed here.)

Determining whether the market is over- or under-valued is a difficult exercise indeed. But by focusing only on those companies for which it is easier to compute earnings (circle of competence), and ensuring that companies trade at discounts to those earnings (margin of safety), investors put themselves in positions to profit in the long-term whether the aggregate market offers potential or not.

Disclosure: Author has a long position in shares of KTCC


Anonymous said...

Why did Key Tronic choose to pay more taxes this year than the previous two? In 2007 and 2008, their effective tax rate was less than 5%. In 2009, it was more than 10%.

Anonymous said...

I'd be interested to hear your thoughts on HDNG. They're cash flow positive but are selling at 43% of adjusted* tangible book value.

*After subtracting an expected write-down of $10m in the back half of this year, $3m for severance and $10m in intangible assets.

Saj Karsan said...

Hi Anon1,

I'm not sure they choose to pay more taxes. The tax-loss carryfowards are based in certain geographies, so earnings outside of these geographies is still taxed at the regional rate.

Hi Anon2,

I've written about HDNG here.