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!
Rio Tinto
Today, I’m analysing mining giant Rio Tinto (LSE: RIO) (NYSE: RIO.US), the data for which is summarised in the table below.
| Share price 3,240p | Forecast EPS | +/- consensus | P/E* |
|---|---|---|---|
| Consensus | 553 cents | n/a | 9.9 |
| Bull extreme | 713 cents | +29% | 7.7 |
| Bear extreme | 457 cents | -17% | 12.0 |
* EPS at current $ to £ exchange rate of 1.695
As you can see, the most bullish EPS forecast is 29% higher than the consensus, while the most bearish is 17% lower. This 46% spread is just a little wider than that of the average blue-chip company.
The spread has been considerably wider in the last couple of years, marked by industry-wide uncertainties, and a new chief executive with a shift of strategy at Rio. But the narrower spread today suggests that in the eyes of the City analysts visibility has improved on the macro-outlook and/or the progress of the new strategy at Rio. The breadth of plausible earnings scenarios has become less extreme.
Rio has been one of the most aggressive cost cutters among the big miners over the past two years, as well as selling non-core assets. While 2014 will see that programme continue to play out, the chief executive’s confidence is on the rise, with the chief executive saying recently that his team will be preparing new capital investment proposals to be put to the board in 2015.
As, Rio’s current P/E rating shows, the market seems to lack faith. The consensus puts the stock into value single-digit territory, while the bull extreme gives a bargain-basement reading of 7.7. Even on the most bearish forecast, Rio is trading on a P/E of 12 — comfortably below the FTSE 100 long-term average of 14.
As such, I reckon the risk-reward balance is tipped decidedly towards reward for far-sighted investors.