By now, if you've seen any of our comments on Twitter, you probably know that we're cheap. Paying up for anything, a car, a home, a movie, and especially stocks/bonds is against our personal religion and something we try to avoid at all costs. As investors, everyone should avoid buying expensive stocks/bonds.
Specifically regarding bonds, we really only like to pay below par for a bond, being that the bond will be redeemed for par...we just find it too difficult to figure out when you get out of a bond if you already bought it for more than par. Obviously, if you hold a bond that you bought for more than par to maturity...you're going to lose money when the bond principle is paid out since all bonds end up at par by maturity. So, a quick lesson on bonds for you individual investors out there is to try and only by bonds when you can get them below par...or you may fall into a yield trap (which you can do when you buy them too far below par as well). We'll save the bond less for another day.
Today, since we were asked about valuation, and how we use it, we're going to talk about stocks. P/E and recently PEG, are the two things we use before we even look at a stock further. Often, if a stock has a P/E over 18...we just don't even take a look at it. BUT, there are a couple metrics that we use that will let us buy a stock with a P/E north of 18 and stick to our discipline.
One of the things we'll use to buy a stock with a P/E north of 18 is forward P/E. So, trailing P/E is valuation based on earnings already in the book...so nothing really to figure out there because everything you're looking at (P, E, and M (the multiple)) is real time and you can trust it. Forward P/E, that's the P/E based on either guidance from the company OR from analysts when the company doesn't give forward guidance. When we see a stock with a current P/E that's HUGE, but a forward P/E that's in our range...we get very interested. It's a simple math problem from there. For more on P/E, check out the video from our YouTube Channel on how to do the math (it's easier to watch then to write it out).
EMC is a perfect example of a stock that has a P/E of 32.04, but a forward P/E of 14.2. That's EXACTLY what we want to see. If those forward earnings come to fruition, then we could see the stock trade BACK UP to something close to 32 (since it trades there now and people still own it). So we'll say, forward earnings are $1.36 ($19.45 current price divided by 14.2 forward P/E (19.45/14.2) = 1.36 in earnings). Then, we apply a discounted multiple back on the earnings. If it trades at 32 now...what if it trades with a P/E of 20, you get a stock price of $27.39. That's about $8 higher than the stock trades at right now...we double check the PEG (that's P/E dividend by long term growth rate) and we see that EMC trades with a 0.99 PEG...so the future earnings SHOULD be higher than current earnings and the stock is actually "cheap" and can be bought here safely.
PEG is like taking the temperature for us. A stock may look healthy based on the P/E, but may actually be overheated if the PEG is too high. A PEG over 2 usually signals to us that the growth really isn't there (or there are not enough analysts out there that think it's there and so no one's model includes high growth in it) and we have to believe everyone else that values the company is wrong and we're right. We usually don't like to make that bet, so we avoid stocks with a PEG over 2.
Walking away from stocks with high P/E multiples and a PEG over 2 means that we'll often miss some of the market's hottest stocks. That's OK, those that follow us have to know that we're value managers, not growth managers over here. Every now and then we get up the guts to buy something like VMWare (which we caught for 22 points) or Amazon (which we flagged as a buy at $70/share)...but then we get off before most people do when we catch a move like that because we're value investors over here...not growth. Something like a SalesForce.com is a PERFECT example of something that we'd normally stay away from because P/E is 140, forward P/E is 60 and the PEG is 2.83. BUT, if we believe that analysts have estimates that are too low, and that the "G" in PEG could be higher, or that E will come in better than expected...that will bring down P/E (momentarily) to something more reasonable. If you believe in a strong, secular trend, like cloud computing, then owning SalesForce.com (CRM) might not be as reckless as valuation indicates (but you MUST be right about the growth and earnings). If you're wrong, and you own a stock like Google, when they pulled out of China, the decline will be breathtaking ($150 was erased off Google's stock price in a matter of weeks). Those kinds of losses can be devastating.
What is one instance when we will ignore a high PEG? When we don't need/want growth. Take for instance, an MLP (Master Limited Partnership) that we really don't care if they grow that much...we just want the dividend paid consistently. We're not that concerned about the PEG as these companies rarely grow at the rate of an Apple, Google, Amazon, VMWare, SalesForce.com, etc. Take one of our favorite, Calumet Specialty Products Partners (CLMT), it trades with a forward P/E of 11.42 (that's great for us), but the PEG is 9.41. That's a terrible PEG, but we don't expect big growth out of a company like CLMT. Look at KMP, a P/E of 34.41 and a PEG of 11.75. That is TERRIBLE if you compare it to other companies...but we own KMP for the dividend (although, KMP is now getting expensive compared to other MLPs and you may want to consider swapping out of KMP and into another MLP before everyone else figures that out as well and does it before you do, leaving you with a lower stock price). The same is true of Kilroy Realty...and many other big dividend paying stocks that don't have big growth...you can ignore PEG (except you probably want to use it to compare it to other stocks in the same category).
There are reasons to use P/E and PEG, and some reasons not to (in certain circumstances)...but, as a general rule for us...cheaper is always better.