The forward price-to-earnings (P/E) ratio — share price divided by the consensus of analysts’ forecasts for earnings per share (EPS) — is probably the single most popular valuation measure used by investors.
However, it can pay to look beyond the consensus to the spread between the most bullish and bearish EPS forecasts. The table below shows the effect of different 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 consensus 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!
Diageo
Today, I’m analysing Footsie drinks giant Diageo (LSE: DGE) (NYSE: DEO.US), the data for which is summarised in the table below.
| Share price 1,815p | Forecast EPS | +/- consensus | P/E |
|---|---|---|---|
| Consensus | 99.9p | n/a | 18.2 |
| Bull extreme | 112.9p | +13% | 16.1 |
| Bear extreme | 90.0p | -10% | 20.2 |
As you can see, the most bullish EPS forecast is 13% higher than the consensus, while the most bearish is 10% lower. This 23% spread matches that of drinks peer SABMiller, and is much narrower than the 40% spread of the average blue-chip company.
Part of the reason why analysts see a relatively narrow range of plausible earnings scenarios is that Diageo’s financial year runs to 30 June. We’ve already had half-year results — and a nine-month update last week — so analysts have a clearer view of the full-year out-turn than for companies with a calendar year end.
But we shouldn’t make too much of that, because the EPS spread for Diageo further out, for the year to June 2015, remains narrow at 26%. The main reason for the tighter-than-average spread is that the drinks business is more predictable than a lot of other businesses.
Earnings visibility in the drinks industry, and Diageo’s position as the world’s leading spirits company, comes at a price: a P/E that, even on the most bullish EPS forecast, is well above the FTSE 100 long-term average of 14.
While Diageo’s P/E has been even higher at times in the past, it has also on occasions been lower. So, we’re looking at a share that is currently trading somewhere within the middle of its historical range.