Why dose some business get the PE it should get???

[kaihangkk]

Hi ! I am new to investing and I have got this question in my head.
I have done some research on some good companies(0857.HK: Summary for PETROCHINA - Yahoo! Finance), the growth rate were awesome, ranging between 16-17%. However, when i check their historical PE, they are usually around 10-15 only.
In Phil Town's book, he said when we caculate the Sticker price, we could use 2 x estimated growth rate to find the future PE(which if i use my numbers, i would get around 33) and use the lower between historical and the rule #1
The question I have is, wouldn't that make the Margin of Safety for the company really small that it seems impossible to be to safe to buy?

[kaihangkk]

sry.. the title should be why does some business doesnt get the PE it should get

[joshuat]

Well, that is kind of the point. Buffett made 3.5 Billion in profit buying Petrochina precisely because it was trading at such a low PE.

Let's talk about businesses (not stocks) for the moment. We own a business because of an expectation of future cash flows. The less we pay for that business, the better our profit margin. No kidding, you are all saying. :) Naturally, we would normally want to buy the business that generates the most cash flows, but if we can get a low enough price for an average business, it can work out just as well for us. On the other hand, when business gets tough, the average business won't do as well, so we mostly look for those great business, and content ourselves with paying a good to decent price.

Okay, but when you introduce a market on top of that, all you are doing is adding daily bids on what people are willing to pay for a piece of the business. This sometimes gets pretty disassociated with the reality of the business. Credit crunch? Down goes the prices. Etc. But, in the long run, stock prices are going to eventually reflect the value of the business.

Stocks were extremely undervalued in Asian countries. Buffett saw that and pounced.

In short, those low prices (which usually means lower PE than you would expect for the business) are the buying opportunities. If the PE is already high (relative to what the business can command), then you are buying a stock with all of the future earnings built into the price. Why would you buy that? The only way to make serious money on that is either for the stock to ride a bubble up, or for the business to outperform beyond anyone's imagination.

It's the Buffett formula. Buy great businesses, run by great management, at a great price. That doesn't come along often. When it does, buy.

[npg]

What governs the price of a security on the stock exchange? Supply and demand. Supply and demand of a security have no strict correlation with the performance of that business. They may coincide, but not necessarily so.

What does an investor try to do? He tries to guess the future performance of a business and pay a price less than that for a share of the earnings in that business. In that sense every investor is effectively a value investor. Nobody in their right mind would want to pay more than he expects the business to perform.

Unless you have the capability of seeing into the future (we can see several billion years into the past via the Hubble telescope) and come up with a mathematical framework for this, all calculations of that sort are effectively guesses. So when you do things like PE is 2 x growth rate, then you effectively make one guess (the PE) out of another guess (the expected growth rate).

Therefore it pays well to understand that one's guesses are not always right. That is where a margin of safety comes in. But even with a perceived margin of safety, one's guess can still be off! That's a huge dilemma. Especially when coming from a culture that does not encourage independent thinking and is generally still spiked with superstitions in all aspects of our life.

So what PE should one take? That question can be debated to the end of time (and time will end if you understand the big rip theory) because there is no right answer. You may want to take a historical maximum range, but that can distort the picture as well. Just consider what makes a PE go up. Generally that happens when the price increases for the same earnings, or the price remains more or less the same but the earnings dropped. Looking at companies like VLO or USG and countless others, they sometimes had their earnings drop but a lesser deprecation in price because less people were willing to part with their stock. In the case of VLO that catapulted the PE from 5 to 50. In the case of EBAY the PE went from 30 to 120.

So it all boils down to one's ability of making sensible estimates using figures that are most likely for that industry. There is no formula.

As far as the PE goes, one may use simplistic estimates taking twice the estimated growth rate, but it rarely pans out that way. I would use the historical maximum and look for a very likely pattern.

One gets to know a stock much better after holding it for a few years ;)