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Introduction

In a recent article that I wrote for Seeking Alpha on the importance of using fair valuation as a decision criteria, (here) well known Seeking Alpha commenter Chowder called me out on one of my 10 Rules for Portfolio Selection (detailed here). Specifically, he called me out for number 5 - P/E Ratio less than 15. Using PEP as an example, Chowder commented:

Over the last 20 years the normal PE for PEP has been 22.0. The current PE for PEP is 19.2. It is currently below its normal PE.

The operating earnings over this period of time has been 7.9% The estimated earnings growth going forward is 8.4%.

What makes you think you'll see PEP at a PE of 15 or less?

After a bit of back and forth, I am thinking that he is right. While the P/E at 15 rule is a good basis for using valuation as a whole, each company has its own valuation for good reason. Understanding the range, what drives that valuation and a company's historic value can help an investor make an informed decision.

P/E Ratios Over Time

Below is a table of 20 top stocks that many DGIs would have in their portfolio. Listed beside each is the historic P/E ratio for every 2 years at the company's fiscal calendar close. For example, the 10-year value would represent the price and earnings at the close of 2003. The current P/E is as of this writing on December 10, 2013. The last column is the mean of the ten year historic P/E ratios.

Table of P/E Ratios Over Time

Ticker

10 Yr

8 Yr

6 Yr

4 Yr

2 Yr

Current

Mean

ADM

18.4

13.4

10.0

10.1

9.6

18.9

14.1

AFL

23.8

15.9

18.9

14.5

10.3

10.1

15.2

BEN

20.0

21.8

13.2

16.9

14.0

16.3

17.7

CAT

27.8

19.8

21.9

17.9

21.7

16.5

20.0

COP

7.3

4.6

9.3

12.0

6.2

10.4

6.3

CVX

12.5

8.7

10.6

14.7

7.9

10.1

9.6

DE

10.8

11.9

8.2

17.7

11.2

10.1

13.2

ED

18.1

15.8

14.1

14.5

17.4

15.7

15.3

INTC

37.7

17.8

22.6

26.5

10.1

13.4

19.5

JNJ

21.5

17.4

18.4

14.6

18.8

21.1

17.5

KO

28.5

19.8

23.8

19.4

18.9

20.7

20.3

MCD

21.6

16.5

29.8

15.2

19.0

17.2

18.5

MDT

31.5

24.0

25.0

15.7

11.2

15.4

21.0

PEP

22.7

24.7

22.3

16.1

16.5

19.4

19.4

SWK

29.8

15.2

12.1

18.5

17.0

22.4

19.2

T

10.2

17.2

21.4

13.2

45.8

24.5

19.0

TEVA

23.6

27.1

19.5

25.2

13.1

84.6

29.9

TGT

18.9

20.2

16.9

15.5

11.9

17.0

15.5

WMT

26.0

17.2

16.2

14.4

13.6

15.3

16.7

XOM

12.7

9.8

12.9

17.1

10.1

12.5

11.7

Looking at the table above, I see three trends. Below is a graphical representation of those three. The first trend is a continual decline in the P/E over the past 10 years. The thick red and blue lines below represent the first type. Both AFL (red) and WMT (blue) show this trend. Both have a recent bounce, but for the most part, the trend is negative.

The second trend is that of a 'U' shape. The trend starts out high 10 years ago, meets a low in the past 3 years and has shown a stronger recovery in the past 3 years. This trend is represented below by KO and ADM. Both are dashed lines. KO is purple and ADM is blue. This model presents the opportunity for the investor to make outsized return as the historic P/E reverts to the mean.

The last trend is similar to the shape of a 'W'. CAT represents a company that oscillates quickly between P/E values. It fell in and out of favor over the last 10 years based on many things. The 10-year P/E ratio was aggressively high around 27. After that initial value, the P/E has bounced between 15 and 21. Overall CAT also shows a downward trend similar to AFL and WMT. It is represented in the small green dashes.

(click to enlarge)

Reversion to Mean

Ticker

Current

Mean

Gap

ADM

18.9

14.1

-4.8

AFL

10.1

15.2

5.1

BEN

16.3

17.7

1.4

CAT

16.5

20.0

3.5

COP

10.4

6.3

-4.1

CVX

10.1

9.6

-0.4

DE

10.1

13.2

3.1

ED

15.7

15.3

-0.4

INTC

13.4

19.5

6.0

JNJ

21.1

17.5

-3.6

KO

20.7

20.3

-0.4

MCD

17.2

18.5

1.3

MDT

15.4

21.0

5.6

PEP

19.4

19.4

0.0

SWK

22.4

19.2

-3.2

T

24.5

19.0

-5.5

TEVA

84.6

29.9

-54.8

TGT

17.0

15.5

-1.5

WMT

15.3

16.7

1.4

XOM

12.5

11.7

-0.8

One of the interesting aspects of this information is looking at the current P/E ratio versus the historic average. The column Gap above is calculated by subtracting the current P/E ratio from the mean. A negative value shows the current P/E ratio above the historic average. A positive value is better for the long-term investor. Again, this is just to highlight the gap and provide you with something to look for in order to explain the gap.

INTC is a great example. 10 years ago, the company was doing well and could not fail. You could hardly find a mistake in their business. Fast-forward to today and the company is at a crossroads. After getting spanked by missing the mobile market demand the company needs to catch-up in mobile and ensure that it does not miss the next wave of processor demand.

MDT is another good example. As the company transitions from a growth company to a more traditional, lower growth organization, the P/E ratio declines from an average of 21 to a more reasonable 15.

On the other side there is CAT. As identified above, the company falls in and out of favor as the market tries to determine concerns over the next 5 years. Nobody is really questioning if the company will be fine in 10 years or 20 years. CAT will be around and it will continue to grow as the world demand for food grows. With a 33% gap versus its mean, there is some room for improvement in the P/E ratio as CAT falls back into favor.

Conclusion

In my first article, I highlighted 10 rules that I would use to make decisions on investing. Those rules are shown below. As I learn more from the SA community, I will continue to revise these rules.

  1. Initial yield the greater of 2.5% or 150% of S&P 500 yield at the time of selection.
  2. Chowder Rule: Yield + 5 year growth rate greater than 8%, target greater than 12%.
  3. Chowder Modified Rule for DGI: Yield + 5 year dividend growth rate greater than 10%, but target greater than 12%.
  4. 5 years of earning growth (EBITA), does not require linearity, but linearity is preferred.
  5. P/E Ratio less than 15. It is preferable to have a P/E Ratio less than 10% of the stocks 5 year average P/E Ratio.
  6. Debt to Equity ratio < 50%. This is not a hard rule. It can vary by industry, but the portfolio goal is to be < 50%.
  7. Dividend payout ratio < 60%. I am open to REITs and would make the logical exception to this rule.
  8. Company has price protection or the infamous moat.
  9. Price at least $5 per share.
  10. I have an awareness and understanding of the business model.

Chowder called me out on number 5 specifically. As per usual, Chowder was right. It is faulty logic to suggest that using a flat P/E ratio is a good way to judge all stocks. A better logic is to look at the trend of the P/E ratio over time, identify the pattern and then research what might be causing the various changes to the P/E ratio over time. If no alarms go off from this research, then pick a stock that shows a lower P/E than its historic value. This will provide the opportunity for long term investors to benefit from a reversion to the P/E Ratio mean.

Revised, number 5 should read,"Understand the historic P/E ratio trend. Look for a trend that offers opportunity for reversion to the P/E mean. It is preferable to purchase when the P/E ratio is less than 10% of the stocks 5 year average P/E ratio."

Source: Long-Term Investors Should Use Historic P/E Ratios To Find Hidden Value