Is value investing another complicated term that would take forever to understand? For the man-on-the-street these ratios may not mean much when they are mentioned.

One thing that everyone is familiar with would be to ‘buy cheap, sell expensive’. But the problem here would be ‘How to ascertain at what price the stock is expensive or cheap?’ A measure that is widely used would be the relative measure of valuation. Two ratios are the price-to-earnings (PE) ratio or the price-to-book (PB) ratio.

Price-to-Earnings (PE) Ratio

The PE ratio gives us the price per share divided by the earnings per share (EPS) of a company. If you see that the PE ratio given is an estimated one, it actually means that the earnings are estimated rather than those that are already announced or realised. In an example on the PE ratio, as at 18 December 2008, the PE ratio of Singapore Airlines (SIA) is at 7.6X for 2008 when it is trading at S$11.60, meaning that the stock is trading at about 7.6 times its historical EPS. But what does this 7.6X mean? Is SIA cheap or expensive?

To give a better perspective, we can choose to do a stock-to-market PE ratio analysis. The historical market PE of the Straits Times Index (STI) on the same date is at 6.1X. This essentially means that the stock is trading more expensively than the overall market. But the STI contains of stocks in different industries including Shipping, Banking and Property etc. A comparison with other large airline companies in Developed Asia will show where the airline stands in terms of attractiveness.

Does the same evaluation methodology apply to equity market investing? This table shows a comparison of the estimated PE ratio of Singapore equities and compares it with the other Asian countries that we cover. From the estimated PE ratio we can see that Singapore equities, as represented here by the STI, is at 8.6X, which is lower than the average PE of 10.6X (Data as at 12 December 2008). Thus, we can say that on a relative basis, STI’s PE is more attractive or cheaper than Asia ex-Japan on the whole. For value investing, we would advocate investing into markets which are cheaper than average, cheaper than its peers or lower in comparison to historical levels.

But, what happens when the denominator for the PE ratio turns negative? This could potentially happen during times of crisis. For example, during the current Subprime crisis, US banks and financial institutions with negative earnings would probably show negative PE levels – which does not make any sense. In such a situation, we would be using Price-to-Book (PB) ratio to gauge attractiveness in the value of stocks during similar crises.

Price-to-Book (PB) Ratio Makes More Sense When Earnings Are Negative

The PB ratio is an indication of how much shareholders are paying for the net assets of a company, and as with PE ratios, the lower the ratio, the better. A PB ratio of 1X signifies that the current price of the share is exactly what the company is worth if all its assets were stripped off and sold in drastic circumstances.

Book value is the value of a company's assets net of all liabilities as expressed on its balance sheet, and is estimation of the value of the company if it were to go into liquidation. A case in point would be banks - most of their assets are actually loans made out to borrowers, a relatively homogenous business model across the industry. PB ratios in this case would be a better valuation measure, as loans are rarely valued above their historical costs, leading to a better interpretation of valuations as compared to the PE ratio. The reason would be that the earning component would have already been affected by the massive write-downs. Negative or very low earnings lead to PE ratios which would not be meaningful, as they do not accurately represent the underlying companies’ normal business conditions.

Value Investing Requires Patience

As value investing advocates a strict methodology that is based on facts-driven reasoning and not hype or pessimism. That may mean that value investors are taking some risks in investing in markets/stocks that already have a lot of pessimism being priced in. For example, the estimated PE ratio for Singapore on 12 December is 8.6X – much lower than the 5 year average PE of 15.2X from 2003 to 2008. However, during such a time, even though we know that valuations are cheap for Singapore, with all the pessimism in the market – it really takes some guts and patience to invest into the market. For me, I would think that it take more of patience than guts. Eventually, when market situation, earnings, sentiment all normalize – it is definitely very possible that valuation would very slowly revert to the mean.

Beware of the Value Trap

Some stocks and markets may potentially be a ‘value trap’. This means that they are attractively valued and may appear promising – but might be disappointments at the end of the day. Some markets/stocks that have been trading at low PE multiples of earnings are doing so for a good reason.  If a market suffers from political uncertainty, depressed earnings and lacks near-term catalysts, such a market could stay cheap for a long time. An example would be a country market with low PE that has been relying on electronic exports for an extended period of time. If consumer demand for technology is undergoing a sluggish period without hope for a turnaround in the medium to long term, this market could really take a long time to recover unless the country diversifies into other sectors of growth.

Why Do We Like Value-Investing?

The reason is that we are believers of long term investing and believe in not merely following the latest hype in investing. But we also recognize that there are investors that may not be patient enough to wait for a while for market valuations to revert to the mean after engaging in value investing.

The characteristic of such investors would be growth investors – these are investors that like markets/stocks that may have high valuations but are expected to experience very strong earnings growth in the near to medium term. But of course the risk would be that some of these stocks/markets could be riskier in nature – a high PE level would mean that the price of the market/stock has run up quite a bit already.

Whether it is value or growth investing that you would like to advocate for your investments, it would be important to be consistent in your investment methodology – what would happen if you are a value investor and believe in low PE investments but when markets crash you just simply sell-off your stocks only to regret when equity markets recover that you never stuck to your value investing strategy?

But I have to say that value investors really need to be patient and have faith that equity markets would eventually recover.