One number I always examine when comparing shares is the valuation. Like many investors, I favour the price-to-earnings (P/E) ratio, which takes the company’s share price, and divides it by earnings. It is a useful measurement, but like any number, must be handled with care.
Is the P/E ratio right?
To test how useful it is, I have picked out two FTSE 100 stocks with wildly different ratios, to decide which is the better buy.
Measured by its P/E, Russian steel producer Evraz (LSE: EVR) is one of the biggest bargains on the FTSE 100, trading at a meagre 3.12 times earnings. That is a fraction of the index average of just over 18 times. You don’t often see £5.85bn companies going so cheap.
At the other end of the scale, engineering data and design IT systems specialist Aveva Group (LSE: AVV) looks astonishingly (reassuringly?) expensive at just over 50 times earnings.
Evraz has another astonishingly tempting figure – a forward yield of 12.5%. Cover is 1.3, which is relatively low (2 is ideal), but surprisingly high given the bumper payout.
You won’t be surprised to hear the Evraz share price has had a bad time, falling almost 40% in the last six months (although it is still up 209% over five years). It suffered a bruising after chairman Alexander Abramov and other top shareholders dumped tens of millions of shares in March, and again in July, without explaining why.
The group has also been hit by fears over a slowing global economy, and particularly China, as steel demand slumps, knocking revenues down 6% to $4.2bn. Its fate appears to rest on prospects for a US-China trade deal, and global growth generally. There have been positive signs on both fronts lately, and Evraz is up more than 8% in the last week as a result.
2020 is shaping up to be a bit bumpy, and Evraz seems the volatile type. Earnings are falling 50% this year, with a drop of 11% expected in 2020. This stock is massively risky, just a glance at the valuation tells you that. It’s also tempting, if you fancy a whiff of danger in your portfolio.
Having seen its dizzying valuation, you will not be surprised to hear the Aveva share price has been on a bit of a run. It is up 96% over one year, and 270% over five. I owned this stock, back in the day. I wish I still did, and I’m not the only one kicking myself.
Aveva has posted healthy revenue growth, up 16.5% to £391.9m in the first half, delivering “good growth” across all geographic regions, particularly Asia Pacific.
The £7.52bn group sits on net cash and deposits of £58.6m, and recently jacked up its dividend by 10.7%. Despite this progressive attitude, its yield is at the opposite end of the scale to Evraz, a lowly 1% with cover of 2.2%.
Aveva Group looks set to continue its fabulous momentum, with earnings forecast to rise 18% in the year to 31 March 2020, and 14% the year after that. However, I am unnerved by its valuation, which leaves no room for slips.
I can’t quite bring myself to recommend it for that reason. This time, the valuation has the casting vote.
Harvey Jones has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.