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Price-to-earnings ratio in inflationary environment

Tafara Mtutu:Investment analyst

THE price-to-earnings ratio, commonly known as the P/E ratio, is the most used metric in valuations of listed companies. The ratio relates a company’s earnings to its market value. A company’s earnings figure typically refers to the amount available to investors at the end of a full operating year after all preceding obligations such as interest payments and operating expenses have been taken care of.

The market value of a company is the value of a listed business as determined by market forces. The term “market value” is also used interchangeably with the term “market capitalisation” or “market cap”. The earnings figure aptly incorporates the overall performance of a company over a specific period, making it one of the chief drivers of investment value.

According to Bank of America’s Merrill Lynch Institutional Factor Survey, 81% of respondents considered the P/E when making investment decisions. There are several variations of the P/E ratio, but this article will focus on the Forward P/E ratio, which uses forecasted earnings instead of actual earnings.

The rationale behind the effectiveness of the P/E ratio hinges on its ability to uncover possible mispricing of listed equities. A higher (lower) P/E ratio relative the sector average usually implies that the company is likely over/(under)valued.

For example, if the alcoholic beverages sector has a historical P/E ratio of 20x and a listed alcoholic beverages manufacturer trades on the stock exchange at a P/E ratio of 10x, an investor can easily notice that the alcoholic beverages manufacturer could be under-priced by market forces. These disparities between company and sector P/E ratios are often a source of value creation for active investors.

The P/E is a powerful yet simple tool in investments under a stable economic environment. However, Zimbabwe’s volatile environment since the advent of the interbank in February 2019 and Statutory Instrument (SI) 142 of 2019 later in June has been anything but stable. Of note is the annual inflation rate that surged from 57% in January 2019 to 521% in December 2019.

During periods of hyperinflation, the P/E ratio needs to be adjusted for the rapid change in accounting figures in order to maintain its relevance and reliability. If not, the ratio could be misleading. When adjusting the P/E formula during hyperinflation, one needs to incorporate the subject company’s ability to pass the inflationary effects to the end users.

Companies with a limited pass-through ability tend to experience an increase in operating costs that outweighs the increase in their revenues, resulting in shrinking margins. Such companies are usually players in heavily regulated sectors, as explained in the paragraphs that follow.

Telecommunications
This sector is regulated by the Postal and Telecommunications Regulatory Authority of Zimbabwe (Potraz). Potraz approves any tariffs adjustments before they can be effected by local mobile network operators (MNOs).

When the ZWL/USD parity was disbanded for a floating rate in February 2019, the value of the US dollar moved from ZW$$1 to ZW$$2,50, but tariffs were converted from USD to ZWL at a rate of 1:1 and Potraz was rigid about its stance to maintain the conversion rate of 1:1. Tariffs were later changed in August and October 2019, but the infrequent tariff adjustments vis-a-viz an overwhelming inflation rate meant that the real value of MNOs’ earnings was negatively affected.

Basic materials
Companies in this sector have near zero-ability to implement selling prices that stray away from global commodity prices. The ZSE currently boasts two actively listed basic materials stocks, namely BNC (nickel) and RioZim (gold). RioZim, in particular, has been faced by a strong increase in gold prices as a result of heightened global risk in equities and bonds, but the miner has consistently recorded falling margins because of the unfavourable payment modalities by the country’s sole-gold buyer Fidelity Printers and Refiners (FPR).

The delays in payment for the RioZim’s gold sold by FPR, coupled with a (i) lower-than-black market conversion rates, (ii) foreign currency retentions and (iii) a very short liquidation period for foreign currency, meant that RioZim’s revenues were grossly inadequate to meet the parallel market-based operating expenses and resulted in massive losses in the FY2019 year.

Financial services
The interest rates that were dictated by the central bank since the beginning of 2019 have significantly fallen short in matching the inflation rate in Zimbabwe, and these sub optimal real rate has subdued the lending operations of many banking institutions. Some institutions even stopped offering mortgages to locals because of the inconducive lending rates that place banks at a disadvantage.

The contractual nature of the insurance sector also experienced a lag between premiums and the inflation rate. Insurers charging a fixed ZWL premium for a period of at least three months amid claims whose costs were constantly re-rating in line with inflation resulted in net earnings shrinking to the detriment of these insurers and, in turn, their investors.

The margins of most companies reported volatile margins as a result of their limited ability to pass inflationary costs to their customers. On the other end of the spectrum, the trend in margins for companies with the full ability to pass inflation costs was consistently upwards in the same period.

Unlike companies with a limited inflation pass-through ability, entities in largely unregulated sectors can adopt a pricing model that is based on the replacement cost of inventory.

This model entails pricing current goods at a ZWL price that covers the replacement costs of the inventory in the future. The resulting margins are higher because of the forward-pricing model that incorporates higher inflation rate expectations in a hyperinflationary environment.

Going back to our P/E discussion, we observe that companies with limited inflation pass-through ability tend to trade on very demanding Forward P/E multiples relative to companies without this constraint. Based on earnings estimates, profitable companies with limited inflation-pass through ability trade on an average Forward P/E multiple of 11.4x whereas entities with full ability trade on a cheaper average Forward P/E multiple of 5.8x. Considering an a ZSE average Forward P/E of 10.4x, the figures above imply that there is a greater upside for companies with full inflation pass-through ability relative to those without.

Stringent and rigid regulations are a company’s worst enemy during periods of hyperinflation in Zimbabwe. Fortunately for the consumer, it was a joy it was for the consumer who took a loan at insanely low interest rates and purchased cheap data and voice bundles during Zimbabwe’s hyperinflation period.

However, the country’s inflation rate has been declining slowly after a string of containment measures by the Ministry of Finance and the Reserve Bank of Zimbabwe. The anticipated inflation rate stability will likely plug the losses for heavily regulated entities, all things being equal.

Mtutu is an investment analyst with Morgan&Co. He writes in his personal capacity.

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