Investment valuation using price/earnings ratio

WE have used the P/E ratios more often than we know in our lives concerning purchases and investments. Few realise how important this financial ratio is. At present, this ratio is primarily used for shares or company valuation.

In simple terms, a P/E ratio is the ratio of the price of an investment divided by its earnings. A more technical definition for a company or share valuation would put it as valuation ratio of a company’s current share price compared to its earnings per share (EPS). Let’s say Venecio Bhd shares are trading at RM20 and the recently concluded financial year, resulted in net earnings of RM125mil with 50mil shares issued. Therefore, the EPS is RM2.50 per share (RM125mil/50mil), and that gives a P/E ratio of eight (RM20/RM2.5).

This means that for every ringgit the company makes, investors are willing to pay RM8 for it. There are long debates on the applications of P/E ratio for shares, but we shall not delve into this, rather I’d like to touch on P/E ratios for personal investment evaluations.

Calculation of P/E ratio for a property investment evaluation is pretty straight forward. For a house that yields a rental income of RM1,000 per month, that works out to be RM12,000 per year. With the house valued at RM240,000 that derives to a P/E ratio of 20 times. Based on my experience, this rate seems to be the valuation point of landed properties in the Klang Valley. To be more accurate, some would deduct direct expenses to derive at the net rental income less expense. Rates lower than these could either entail a bargain or a low valuation placed by investors, while rates above would translate as either a premium, or over valuation by investors.

We can also calculate the annual Return on Investment (ROI), simply by dividing the annual rental against the investment value, and this derives to 5%. This is actually the inverse of the P/E ratio, whereby 1 divided by 20 gives 0.05 or 5%.

What this means is that at 5% annual ROI, it will take 20 years (at current rate excluding inflation and other factors) to recoup the investment.

The P/E ratio can also be used if you are evaluating to sell your property (besides having a market price evaluation). For instance, if you had purchased a RM240,000 property, and three years down the road the rental has increased to RM18,000 per annum. Assuming the property P/E ratio remains, then the property should have a valuation of RM360,000 (RM18,000 X 20). This represents a three year cumulative average growth rate (CAGR) of 22.5% which can form a benchmark.

Based on the tables on a few tabulations for properties around the Klang Valley for comparison purposes, a few deductions can be made from the information gathered, as follows :-

● Landed properties generally has higher P/E ratios, as compared to condominiums.
● Condominiums on the other hand, generates better ROIs as compared to landed properties.
● Well established areas calls for higher P/E than new townships, and generate lower ROIs. This can be interpreted as higher investment return potential for new township properties.
● Lower P/E condominiums seem to generate higher ROIs.

A high P/E ratio can mean an over-valued property or a property in which the market places a premium therefore “approved” by market forces. Likewise, a lower P/E can translate as under-valued with a potential to increase. The tabulation has also not considered the maintenance fee that usually entails condominiums, and if this is lessened from the rental, the ROI may reduce to approximate the landed properties.

Depending on your budget and purpose of purchase, you can fit your requirements within this ambit of selection process. There are other considerations as well which should not be excluded. These would include, freehold land or leasehold, built-up, land area, maintenance fee, close approximate to shops, schools, facilities, etc.

The P/E ratio and ROI can be a valuable tool in your property decision making process as shown above. While some of the findings may defer with a bigger sample or new locations, it’s a start to a whole new definition to your house hunting process. You can also track P/E ratios over time, to build a trend in which a growing trend would denote appreciating value.

P/E ratios can also be used to evaluate other investment options, so long as the parameters required for the decision making process can be ascertained.

COMMENT
By RAYMOND ROY TIRUCHELVAM

● The writer, a business planner with Sabic Group of Companies, is “doing more homework today, to make up for those he missed in school.