In his book One Up On Wall Street, legendary fund manager Peter Lynch wrote about a simple method that household investors could use to quickly determine whether a company might be overpriced.
He suggested plotting the earnings line and share prices for the past 10 years and looking at the gaps between the lines. If the share price line rises far above the earnings line, the company could be expensive. I've already applied this method to Flight Centre Travel Group Ltd (ASX: FLT) and Wesfarmers Ltd (ASX: WES), and you can find those articles here and here. Today I decided to look at Australia's biggest biotech – and some would say Australia's best listed company – CSL Limited (ASX: CSL):
With this chart I've done something a little different – I've included a forecast for CSL's full year 2017 earnings. I've assumed that the company delivers 22% growth in earnings per share, based on their recent forecast for 18% to 20% profit growth, plus a few extra % from the share buybacks they're doing. It's also important to note that earnings per share are in USD, whereas the share price is in AUD.
With the benefit of hindsight, we can see that CSL was greatly under-priced from 2008 right through to 2015, due to the high Australian dollar, which has now fallen. If you bought shares during those years, even unknowingly, well done! At the present however, much of the bargain opportunity in CSL appears to have vanished. If we convert 2017's forecast earnings per share into Australian Dollars, CSL still has a Price to Earnings (P/E) ratio of nearly 30. This is fairly pricey and appears to be high by historical standards.
Price is what you pay, value is what you get
Having established (at least according to this method) that the CSL share price is no bargain, investors then need to look at the business. While CSL has competition, the research and patent protection that go into many of CSL's products enable the company to generate large amounts of cash over many years. Furthermore, the company has a strong research pipeline full of new treatments, and uses its ultra-low cost of funding to buy back its own shares, which also helps grow earnings. I would feel much more comfortable paying 30x earnings for CSL shares than I would many other businesses.
