Long time readers know that I use a price earnings ratio of 20 as one of the parameters in my set of screening criteria. In addition, anytime I analyze a company, I always end up with a conclusion of whether I find it overvalued or undervalued in terms of P/E relative to the benchmark of 20.
A common question in my mailbox concerns the reasoning behind using this variable, and the reason why I don’t look at historical P/E ranges or industry P/E ranges when looking at companies.
A P/E of 20 implies an earnings yield of 5% by the way. I set this parameter back in 2007- 2008, when yields on treasury bonds were about 5%. If yields on treasury bonds increase above 6 – 7%, I would likely require a P/E of about 15 for screening purposes.
The reality is that I use that P/E of 20 as a way to screen out companies that trade at a higher P/E than 20. I am not willing to pay for a high valuation above 20 times earnings, especially for mature dividend growth companies. However, I do not use this P/E in a vacuum to select companies. Instead I use it as one of the tools to compare individual companies that are valued attractively at the present.
I use this criterion for screening purposes, as a way to narrow down the list of qualified opportunities to a more manageable level. I also use other criterion in my screening, such as requirements for minimum yield (2.50%), 5 and 10 year annual dividend growth (6%/year), and dividend sustainability (payout ratio below 60%). However for the purposes of this exercise, I am not going to go into much detail on those.
I applied those results to the list of dividend champions, and received the following output:
As you can see, I try to allocate my funds in what I believe to be the best ideas at the time. I do not believe in the strategy of accumulating cash, and waiting for lower prices from there. I try to balance obtaining the most earnings yield, with the highest probability of growth, for every dollar I put to use today. However, I also face the constraint that I can make only 24 – 36 purchases per year, and that I want to have a diversified portfolio of securities.
If you look at the screen, Chevron (CVX) is on the top of the list by valuation. Therefore, if I was just starting out, I would analyse and potentially buy Chevron in the first month, then maybe analyse and buy some Exxon Mobil (XOM) the next, followed by some Helmerich & Payne (HP) in the third month. If I had not analyzed Helmerich & Payne (HP) and Weyco Group (WEYS) before, I would need to add them to my list for further research, before I allocate any capital to them. I have done what I describe in this article for the past 6 years, and it has worked fine for me.
I do not look at P/E ratios for industry and in terms of historical ranges. To understand why, let’s walk through an example where you have two companies, one which typically sells at 8 – 12 times earnings and another which sells at 18 – 24 times earnings. Both grow dividends at 7%/year, and both yield 2.50%. We would also assume that earnings are relatively stable in both, there is an equal history of dividend growth, and both companies have some sort of durable competitive advantage. Company A trades at the top end of its P/E valuation range (P/E of 12), while company B trades at the low end of its valuation range (P/E of 18). If I was just getting started investing, I would choose company A any time over company B. This is because I am getting more earnings yield for each dollar I invest. This also provides the company with certain options such as share buybacks to boost earnings per share. This could be more accretive to shareholders of company A than for those of company B. It doesn't matter that the P/E is at the top of the range for company A, because I am getting more value for my dollars invested.
Of course if I already have exposure to company A, I would then start allocating funds to company B, which is the next best thing to put my money in. I will also do it because I like to be diversified and not keep all my eggs in one basket.
So as you can see, my method of screening provides a very good launching pad for evaluating opportunity cost, and selecting the most optimal investments at the time. It is superior to looking at past P/E ratios and industry P/E ratios, because it focuses on finding value today, relative to the rest of the market opportunities of the day.
To summarize, I use the P/E as one of the tools to narrow down list of prospects to a manageable level, and then help me to choose between dividend stocks. This low P/E, coupled with my qualitative and quantitative analysis of companies, helps me identify and purchase shares in the best bargains at the present moment. I have money to invest every month, so this P/E of 20 helps me avoid overvalued securities, and helps me to find the best bargains in the market at the time I have to allocate my capital.
Full Disclosure: Long CVX, XOM, WMT, MCD, PEP, JNJ, KMB & TGT
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