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!
Should you invest £1,000 in National Grid right now?
When investing expert Mark Rogers has a stock tip, it can pay to listen. After all, the flagship Motley Fool Share Advisor newsletter he has run for nearly a decade has provided thousands of paying members with top stock recommendations from the UK and US markets. And right now, Mark thinks there are 6 standout stocks that investors should consider buying. Want to see if National Grid made the list?
Centrica
Today, I’m analysing the British Gas owner Centrica (LSE: CNA). The data for the year ending December 2014 is summarised in the table below.
| Share price 330p | Forecast EPS | +/- consensus | P/E |
|---|---|---|---|
| Consensus | 25.7p | n/a | 12.8 |
| Bull extreme | 31.0p | +21% | 10.6 |
| Bear extreme | 24.0p | -7% | 13.8 |
As you can see, with the most bullish EPS forecast 21% higher than the consensus, and the most bearish 7% lower, the 28% spread is narrower than the 40% spread of the average blue-chip company.
Regulated utilities, which generally give management — and City analysts — good visibility on earnings, typically have some of the tightest forecast EPS spreads around. Predictability makes for a relatively limited range of plausible earnings scenarios.
However, while Centrica’s 28% spread is lower than average, and on a par with that of fellow utility SSE, the spread can be expected to be lower still in normal circumstances. Circumstances haven’t been normal, though, since Labour leader Ed Miliband pledged last autumn that an incoming Labour government would freeze prices and break up the ‘Big Six’ energy firms.
Centrica has described the subsequent escalation of public, regulatory and political utilities-bashing as “unprecedented”. The company’s top executives have had enough: we’ve seen finance director Nick Luff quit to join academic publisher Reed Elsevier, while longstanding CEO Sam Laidlaw is set to depart, too.
The result of all this, is that there is now a wider range of earnings forecasts among the City experts who analyse consumer-facing energy firms, such as Centrica and SSE, than we’d normally expect to see for a utility. Non-consumer-facing National Grid, for example, has a forecast EPS spread of just 6% for its financial year ending March 2014 (results due next month), and 17% for 2015.
Not surprisingly, a nervy market has sent Centrica’s shares well down from their 52-week high of over 400p. As such, even the bear extreme EPS forecast now gives a P/E below (just below) the long-term FTSE 100 average of 14. On the face of it, this could be an opportunity for long-term investors to profit. But there is a risk of more radical political and regulatory interference than is currently in the price.
