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!
British American Tobacco
Today, I’m analysing Footsie tobacco giant British American Tobacco (LSE: BATS) (NYSE: BTI.US), the data for which is summarised in the table below.
| Share price 3,459p | Forecast EPS | +/- consensus | P/E |
|---|---|---|---|
| Consensus | 215.8p | n/a | 16.0 |
| Bull extreme | 229.9p | +7% | 15.0 |
| Bear extreme | 209.0p | -3% | 16.6 |
As you can see, the most bullish EPS forecast is 7% higher than the consensus, while the most bearish is 3% lower. This 10% spread — which is on a par with sector peer Imperial Tobacco — is far narrower than 40% spread of the average blue-chip company.
Earnings visibility in the tobacco industry is relatively good. Barriers to entry are high, so there are no sudden shocks to the market from new entrants upsetting the cosy dominance of the main players, while the fight between the main players for market share is tempered by the brand loyalty of smokers. In short, nothing much changes very quickly in this industry, making analysts’ earnings forecasts far less variable than in many other sectors.
The price investors have to pay for BAT’s good earnings visibility and level of confidence in the earnings multiple — a P/E within a tight range of 15 to 16.6 (consensus 16) — is a premium to the long-term FTSE 100 average of 14.
However, a look at BAT’s rival Imperial Tobacco tells us that company-specific factors are also in play. While Imperial has the same narrow EPS spread as BAT, that spread is around a much lower consensus P/E of 12.2.
BAT has advantages over Imperial that are recognised by the market, including scale (676 billion cigarette volumes versus Imperial’s 317 billion) and geographical diversification (nicely balanced internationally compared with Imperial’s much greater reliance on the UK and Europe).
While BAT probably deserves to be at a premium to Imperial, and the wider market, it has been possible to pick the stock up on a P/E closer to the long-term FTSE 100 historical average — indeed, as recently as two months ago.