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!
Sainsbury’s
Today, I’m analysing the UK’s number two supermarket J Sainsbury (LSE: SBRY) (NASDAQOTH: JSAIY.US). The data for the company’s financial year ending March 2015 is summarised in the table below.
| Share price 340p | Forecast EPS |
+/- consensus |
P/E |
|---|---|---|---|
| Consensus | 30.7p | n/a | 11.1 |
| Bull extreme | 36.2p | +18% | 9.4 |
| Bear extreme | 24.6p | -20% | 13.8 |
As you can see, with the most bullish EPS forecast 18% higher than the consensus, and the most bearish 20% lower, the 38% spread is just about in line with the 40% spread of the average blue-chip company.
Sainsbury’s spread was narrower not so long ago, as the company routinely increased like-for-like sales quarter after quarter. However, like-for-likes turned negative in the first quarter of this year, and analysts are starting to see a slightly wider range of plausible earnings scenarios for 2014/15.
While Sainsbury’s is at the upmarket end of the middle-ground supermarkets, recent price-war volleys from Wm. Morrison Supermarkets and Tesco are also probably feeding into analysts’ views on Sainsbury’s earnings to a greater or lesser degree.
Value or trap?
In terms of valuation, Sainsbury’s consensus P/E of 11.1 is around the same as Tesco’s, as is the spread between the bull and bear extremes. The fact that even the most bearish P/E is a tad below the FTSE 100 long-term average of 14 tells us that the market is cautious on the sector.
Sainsbury’s management says it continues to see “significant opportunities for growth”, and remains confident the company will outperform its peers in the year ahead. If Sainsbury’s delivers, and the most bullish analyst is on the mark, the P/E of 9.4 would clearly be good value.
A more bearish view might be that after a profit warning from Tesco over two years ago, and one from Morrisons this year, it’s only a matter of time before Sainsbury’s has a stumble. And if that happened, the current P/E range — even though currently on the value side of the blue-chip average — would prove to have been something of a trap.
Either way, though, I think it’s become clear that the industry is beginning to undergo a major structural, rather than cyclical, shift. The quality end — represented by Waitrose and Marks & Spencer — is thriving, the discount end — represented by Aldi and Lidl — is gaining market share hand over first, whilst the middle segment is having its pips squeezed mercilessly.
The truth is, no one really knows how a seachange in the sector will play out, and what the supermarket landscape will look like five years from now. Much will depend on actions the participants have yet to take.