A low price-to-earnings ratio is often one of the first things investors look for when searching for undervalued stocks. The logic seems simple. If one company trades at five times earnings while another trades at 20 times, the first company appears much cheaper.
But a low P/E does not necessarily mean that the market has mispriced a stock. Sometimes, the low valuation reflects what investors expect from the company in the years ahead.
This idea was discussed by investment analyst Henry Ong in his Philippine Daily Inquirer article, “Why a low P/E does not always mean a stock is cheap.” Ong explained that investors can understand P/E better by converting it into an earnings yield and examining the return and growth expectations behind the valuation.
Financial Adviser expanded this framework across 30 companies in the PSE index to see what their current valuations may be telling investors.
The results show why some of the cheapest-looking stocks may also carry some of the weakest expectations about future earnings.
An earnings yield is simply the inverse of the P/E ratio. If a stock trades at 10 times earnings, investors are paying ₱10 for every ₱1 of earnings. Turn the ratio around and the stock has an earnings yield of 10 percent.
This makes P/E easier to understand. Instead of asking how many pesos investors are paying for every peso of earnings, we can ask how much current earnings they are getting for the price they pay.
GT Capital, for example, has the lowest P/E in our sample at only 3.35 times earnings. This translates into an earnings yield of 29.9 percent. DigiPlus follows at 4.05 times with an earnings yield of 24.7 percent, while San Miguel trades at 4.11 times with an earnings yield of 24.4 percent.
At first glance, these figures look extremely attractive. But there is another side to a high earnings yield.
Why a high earnings yield can signal weak expectations
Investors do not decide how much to pay for a stock based only on how much the company earns today. They also consider the risks they are taking and, importantly, what they think will happen to the company’s earnings in the future.
If investors expect a company to grow strongly for many years, they may be willing to pay a high price for its current earnings because they expect those earnings to become much larger in the future.
A higher share price relative to current earnings results in a higher P/E and, consequently, a lower earnings yield.
The opposite can happen when investors have doubts about future growth. If they believe today’s earnings may not be sustainable, they will be less willing to pay a high price for them. The stock can then trade at a low P/E, which produces a high earnings yield.
This relationship helps explain why a very high earnings yield can actually produce a negative implied growth rate in our framework.
What GT Capital’s low P/E may be telling investors
Consider GT Capital. Its earnings yield is 29.9 percent, while our estimated required return for the stock is only 13.89 percent. At first, this seems strange. If investors require a return of only 13.89 percent but current earnings represent 29.9 percent of the share price, shouldn’t the difference be positive?
The key is to ask why investors are willing to pay such a low price for those earnings in the first place.
If investors were confident that GT Capital could maintain and grow its present level of earnings over the long term, they might be willing to pay more for the stock. As the share price rose, its P/E would increase and its earnings yield would fall.
But investors are currently willing to pay only about 3.35 times GT Capital’s earnings. In effect, the market is placing a large discount on every peso of earnings the company produces today.
Why?
One possible explanation is that investors do not expect today’s earnings to continue at the same level indefinitely. They may expect profits to normalize, decline or grow more slowly in the future. Because of those expectations, investors demand a much higher current earnings yield before they are willing to own the stock.
This is the relationship described in Ong’s Inquirer article. In the simplified framework, earnings yield reflects the return investors require from owning the stock less the long-term growth expected from earnings. Higher expected growth allows investors to accept a lower earnings yield and pay a higher P/E.
We can express it as:
Earnings Yield = Required Return − Implied Growth
For GT Capital:
29.9% = 13.89% − Implied Growth
Rearranging the equation gives an implied long-term growth rate of about negative 16 percent.
The negative figure does not mean that GT Capital’s 29.9-percent earnings yield is bad. Neither does it mean that its earnings are forecast to fall by 16 percent every year.
Rather, it tells us that the stock’s current price places a substantial discount on today’s earnings. Under our simplified framework, the very high earnings yield relative to the required return reflects weak expectations about how much of those earnings can be sustained over the long term.
This shows that implied growth is not an earnings forecast. Ong also cautioned in his Inquirer article that these estimates may not capture all the business risks associated with each company and should not be interpreted as predictions that earnings will decline at the calculated rates.
When negative implied growth can become an opportunity
This is where the framework becomes useful for value investors.
A negative implied growth rate can mean that the market has good reasons to expect weaker earnings. But it can also mean that investors have become too pessimistic.
If GT Capital’s earnings prove more sustainable than its 3.35-times P/E appears to assume, the stock could eventually command a higher valuation. If today’s earnings are unusually high and eventually fall substantially, however, the low P/E may simply be reflecting that risk.
The same question can be asked of several other low-P/E stocks.
San Miguel trades at 4.11 times earnings, equivalent to an earnings yield of 24.4 percent. Against its estimated required return of 10.29 percent, the framework produces implied growth of about negative 14.1 percent.
China Banking trades at 4.89 times with an earnings yield of 20.4 percent and implied growth of negative 13.8 percent. LT Group trades at 4.97 times with implied growth of negative 10.3 percent, while RL Commercial REIT trades at 5.07 times with implied growth of negative 10.8 percent.
These stocks look cheap based on P/E. But their low valuations also tell us that the market is unwilling to pay very much for their current earnings.
This is very different from saying that all of them are undervalued.
In fact, 14 of the 30 companies in our sample have negative implied long-term growth, while 16 have positive implied growth. Most of the stocks at the very bottom of the P/E rankings fall into the negative-growth group.
Why higher-P/E stocks tell a different story
The contrast becomes clearer as we move toward higher-P/E companies.
ICTSI trades at 27.48 times earnings, which gives it an earnings yield of only 3.6 percent. Yet its estimated required return is 13.77 percent. Under the same framework, this produces positive implied growth of about 10.1 percent.
Why would investors accept an earnings yield of only 3.6 percent when they require a much higher return?
Because they are not paying only for today’s earnings. The high P/E suggests that investors expect future earnings growth to make up for the relatively low earnings yield they receive today.
Jollibee Foods shows a similar pattern. Its P/E of 17.49 times produces an earnings yield of only 5.7 percent, but the valuation reflects implied growth of about 8.1 percent. Universal Robina has implied growth of 7.2 percent, while ACEN reflects about 6.5 percent.
This does not automatically make these stocks better investments. The risk has simply changed.
With a low-P/E stock, the investor must ask whether the pessimism reflected in the valuation is justified. With a high-P/E stock, the investor must ask whether the company can actually deliver the growth that investors have already priced into the shares.
This also explains why two companies with almost identical P/E ratios may not necessarily be equally cheap.
Ayala Land trades at 5.94 times earnings, while Semirara Mining trades at 6.01 times. Their earnings yields are almost identical at 16.8 percent and 16.6 percent.
But their estimated required returns are very different.
ALI’s required return of 16.35 percent results in implied growth of only about negative 0.5 percent. Semirara’s lower required return of 9.33 percent produces implied growth of negative 7.3 percent.
This was one of the comparisons in Ong’s original Inquirer analysis and demonstrates why similar P/E ratios can reflect very different expectations about risk and future growth.
What the market’s low P/E is really saying
Across all 30 companies in our analysis, the median P/E is about 8.48 times, equivalent to a median earnings yield of approximately 11.8 percent. More importantly, the median implied long-term growth rate is only about 0.43 percent.
That means the typical valuation in our sample reflects very little long-term earnings growth.
This is consistent with Ong’s conclusion in the Inquirer article. He noted that a median P/E of around 8.5 times translates into an earnings yield of approximately 11.8 percent and, against a similar median required return, implies practically no long-term earnings growth.
This gives investors another way to understand why Philippine stocks can appear unusually cheap.
Low P/E ratios may indeed point to opportunities. But they can also reflect the market’s concerns about future earnings, economic uncertainty and the risks investors believe they are taking.
The real opportunity arises when those expectations turn out to be too pessimistic.
If a company trades at a valuation that assumes weak or declining earnings but subsequently maintains or grows its profits, investors may eventually become willing to pay a higher P/E for the stock. This creates the possibility of both earnings growth and valuation re-rating.
On the other hand, if the market’s concerns prove correct and earnings decline, what appeared to be a cheap stock may not have been cheap at all.
A low P/E, therefore, should not be the conclusion of a valuation analysis. It should be the beginning of one.
The more important question is not simply how low the P/E is, but what expectations about the company’s future are already reflected in that low price—and whether those expectations are right.
