The price-to-earnings (P/E) ratio is probably the single most popular valuation measure used by investors. It’s easy to calculate: share price divided by earnings per share (EPS), with EPS typically being the consensus of City analysts’ forecasts for the current year.
Now, the consensus is a useful shorthand, but it can pay investors to take a closer look at the analysts’ forecasts, and — what I call — ‘play the percentages’. Today, I’m analysing National Grid (LSE: NG) (NYSE: NGG.US).
The spread
By playing the percentages, I mean looking beyond the consensus EPS forecast to the spread between the most bullish and bearish EPS scenarios. The spread varies from company to company, giving different magnitudes of variance in the potential P/E.
The table below shows the effect of different EPS spreads on a company with a consensus P/E of 14 (the long-term FTSE 100 average).
| EPS spread | Bull extreme P/E | Consensus P/E | Bear extreme P/E |
|---|---|---|---|
| Narrow 10% (+ and – 5%) | 13.3 | 14.0 | 14.7 |
| Average 40% (+ and – 20%) | 11.7 | 14.0 | 17.5 |
| Wide 100% (+ and – 50%) | 9.3 | 14.0 | 28.0 |
In the case of the narrow spread, you probably wouldn’t be too unhappy if the bear analyst’s EPS forecast panned out, and you found you’d bought on a P/E of 14.7, rather than the expected 14. But how about if the bear analyst was on the button in the case of the wide spread? Not so happy, I’d imagine!
National Grid
The table below summarises my playing-the-percentages data for National Grid.
| Share price: 820p | Forecast EPS | +/- consensus | P/E |
|---|---|---|---|
| Consensus | 52.0p | n/a | 15.8 |
| Bull extreme | 53.5p | +3% | 15.3 |
| Bear extreme | 50.3p | -3% | 16.3 |
As you can see, the most bullish EPS forecast is just 3% higher than the consensus, while the most bearish is just 3% lower. This 6% spread between the extremes is currently the narrowest among the companies I’m looking at. It means that, barring any major unforeseen events, we can have a high degree of confidence in the earnings multiple we’re paying: a P/E somewhere within a tight band of 15.3 to 16.3.
As a regulated utility, National Grid’s management — and City analysts — have good visibility on earnings; the current UK regulatory pricing regime runs to 2021. Furthermore, National Grid, with its focus on electricity wires and gas pipes, is not mired in the current political hullabaloo and uncertainty surrounding UK consumer-facing utilities, such as Centrica (British Gas) and SSE (Southern Electric and other brands).
The price investors have to pay for National Grid’s good earnings visibility and level of confidence in the earnings multiple is a P/E at a premium to both the long-term FTSE 100 average and the current consensus ratings of Centrica and SSE.
National Grid’s P/E seems a little rich to me right now — the stock was more attractively-valued for much of last year — and I suspect a good chunk of institutional money has moved out of Centrica and SSE, and found its way into National Grid, pushing up the price and rating.