Why Darden Restaurants is so Much Cheaper than SCANA Corp. even though their PE Ratios are Approximately the Same
This article is the second in a series of articles designed to elaborate on the proper utilization and understanding of the PE ratio as an important investing metric. Our first article in this series looked at how the PE ratio could be used to determine overvaluation. With this article we are going to review two companies where each is fairly valued and each has similar current PE ratios. Moreover, both companies offer yields above 3 ½% which is greater than is available on the 30-year Treasury bond (current yield 30-year Treasury bond 3.02%).
Yet even with these similar attributes, almost identical PE ratios and above-average dividend yields, we intend to demonstrate how Darden Restaurants offers a much higher potential future total return. Moreover, even though Darden Restaurants starts out with a lower current yield, its long-term total dividend income stream should also exceed that offered by SCANA Corp. Therefore, even though both of these companies are fairly valued with approximately the same PE ratio, we will illustrate that Darden Restaurants is expected to grow much faster, and therefore, generate a higher total return and a higher total dividend income stream.
In order to accomplish this goal we are going to properly utilize the PE ratio as a relative measuring stick. As previously pointed out in the first article in this series, looking at the PE ratio in a vacuum is an ineffective and mostly irrelevant way to use it. The PE ratio only brings value to security analysis when it is applied and looked at relative to the past, present and future earnings power of the company or companies being analyzed. The PE ratio is a measurement of current valuation in the static sense, but it is a more relevant measurement of valuation when looked at dynamically relative to the future growth potential of the underlying business (earnings growth). Because only when the future growth of the business is correctly ascertained does the PE ratio draw a true picture of valuation.
The PE Ratio Defined
In our first article in this series we provided three extensive definitions and explanations of the PE ratio. Here is the link to that article for those interested in digging a little deeper into the definitional side of the PE ratio. The following are condensed versions of three different ways of looking at the PE ratio (price earnings ratio).
- The simplest definition of the PE ratio is the mathematical formula: PE = Price divided by Earnings.
- This second definition relates to the PE ratio as a measurement of the cost of earnings: PE = How many dollars you must pay to buy one dollar’s worth of a company’s earnings.
- This final definition relates the PE ratio to the time use of money: PE = How many years in advance you are paying for this year’s earnings.
Once again, for a more in-depth explanation of the significance of each of these PE definitions follow this link to the first article in this series. However, the most important point that all of the articles in this series are and will be making, is that the PE ratio is a relative tool. When looked at in a vacuum, as a simple number, the PE ratio literally offers very little value to the analyst or serious investor. For it to have true meaning and provide insight, the user must apply it relative to their expectations of future earnings. More directly stated, the PE ratio should be used to help determine what price you’re paying to purchase future earnings, and therefore, what risk you’re also taking to purchase them.
However and perhaps most importantly, the PE ratio by itself does not provide an insight into the future return the prospective investment might offer. Instead, the PE ratio represents a valuable metric that the user can use to determine whether or not the common stock in question is currently prudently priced. In other words, the PE ratio can be determined to assess valuation, but not necessarily future performance. In order to assess future performance, investors need to look to the rate of change of future earnings growth that they believe the company in question is capable of achieving. In other words, when valuation represents intrinsic value, the future return will become primarily a function of the company’s future rate of earnings growth.
The Underlying Rationale behind Valuation – SCANA Corp (SCG) versus Darden Restaurants Inc. (DRI)
The following analysis compares two companies with very similar PE ratios and very similar dividend yields. Therefore, it is logical to also state that both of these stocks are comparably valued. However, as we will soon see, it is not logical to say that; therefore, they should produce similar future returns. The point being that fair valuation is a function of prudence. In other words, when the stock is fairly valued it simply implies that the price being asked is a rational one for the investor to pay. Moreover, it also implies it would be irrational to believe that the stock could be purchased at a lower valuation. This does not mean it would be impossible to buy the stock at a lower valuation, just that it would be a rare occurrence and therefore unlikely.
The principle behind the above thesis is predicated on the reality that a stream of income has an intrinsic value that is greater than one times the yield. Let’s evaluate this by starting with the extreme and moving to the rational. Let’s assume that you look at an investment with a reliable income stream that you are confident would continue, but that it would do so with no growth. In other words, a fixed income instrument, CD’s, bonds or notes, etc., if you paid a PI (Price to Interest) of one, then your annual yield would be 100%. Clearly, no lender, which is what a fixed income instrument really is, a loan, would be willing to pay you 100% interest per year. On the other hand, a PI of two would mean that your fixed income instrument was paying you a 50% annualized return, etc. These are extreme examples, and ludicrous to think about. However, often the greatest insights come from evaluating the extremes.
This then begs the question: What is a fair or reasonable PE ratio to pay for an investment with a variable income stream like a stock, or for that matter, what is a fair or reasonable PI ratio (Price to Interest) to pay for a fixed income investment like a bond? If you consider and agree that a historical rate of return of between 6% to 8% is both reasonable and common, then the fair value PE or PI falls somewhere between 12.5 (cost of 100% divided by 8% return) and 17 (cost of 100% divided by 6% return). Conceptually, this provides insight into the validity and practicality of a historically normal PE ratio of approximately 14 or 15 (i.e., between the 12.5 to 17 is fair and normal value).
To summarize, the determination of fair value is predicated on the potential yield the investment offers relative to the risk taken to achieve it. Fixed income traditionally offers