It is easy to look at figures or comments in isolation and come to a conclusion. If a company announced a “100% increase in profits” you can’t really argue with that? However, what if competitors had announced a “150% increase in profits”? Do you see what we mean? Everything is relative when looking at investments.
Price-earnings ratio
Those who follow the stock market will be well aware that the price-earnings ratio of different sectors can vary enormously. Technology sectors tend to have a higher price-earnings ratio because of the potential for significant growth. Utilities, including water, electric and gas tend have a relatively low price-earnings ratio with the limited growth rates. However, very often this is supplemented by a healthy dividend yield because many of these utility businesses are effectively cash cows.
Comparing like-for-like
If you look at two technology companies or two airline companies then you are effectively comparing like-for-like. There is relevance in the price-earnings ratio, dividend yield and growth prospects for the future. However, if you start comparing a technology company to an airline company this is where things are less straightforward. Traditionally airline companies will have lower growth rate expectations than their technology counterparts which will be reflected in the current and the price-earnings ratio going forward.
Looking for value
If you have two companies in the same sector with different growth expectations, and different price-earnings ratios, then it can become interesting. Let’s say for example you acquired some company shares on a price-earnings ratio of 15 which then reduced to 10 because of future growth. If we look at another company in the same sector on a price-earnings ratio of 10 with similar growth prospects, then perhaps there may be an opportunity to switch into a better value/lower rated share? If it was able to deliver similar growth in the future then the price-earnings ratio would fall to single figures.
While this example is fairly straightforward, unfortunately the prospects of companies going forward do not tend to mirror each other exactly. Healthy companies in the same sector will tend to go the same direction. While short-term growth rates may differ the long-term trend is probably more similar than you might expect.
Costs to consider
If you’re looking to switch between similar companies with different price-earnings ratios or growth expectations you also need to take into account dealing costs. You have the spread between the buying the selling price, dealing costs and other transactional costs. As these costs are on both the sale and the purchase side they can very quickly begin to eat into the differential.
Warren Buffett has made most of his money by investing long-term in stocks where he believes there is a long-term growth story. However, even he will admit that it is never wrong to take a short-term profit where perhaps the relative value of the share price has pushed too far ahead – i.e. taking too much for granted.
Conclusion
This is all common sense but when you see it written down it does make you think. All investments are relative, relative to the market, relative to the sector and relative to identical competitors. The key to long-term success is to buy shares which offer relatively good value going forward and then cash in your chips when the market catches up. Easier said than done? There are many examples if you look back over recent and historic share price movements. You will be surprised!