Understanding P/E Ratio

An intelligent investor tries a combination of measures to find the intrinsic value of securities.  However there is no such thing as absolute intrinsic value. If things were so easy to calculate, the discipline of value investing would have ceased to exist. It is easy to understand the concept of value (though not many try to understand that) yet it is difficult to actually calculate value. A lot of factors will go in calculating value, and every individual investor will have his own unique figure. Some investors don’t calculate the value; they are satisfied with the mental calculation which tells them that there is enough margin of safety. Some mathematically oriented try to work a precise number using various formulae. Whatever methodology one adopts, one thing is sure: if you have understood the concept of intrinsic value and you equate the value against the price, whether in terms of actual numbers or by means of a mental calculation; the probability of you losing the money is reduced to a great extent.

Fundamental analysis is the discipline of analysing the fundamentals of a company. It is the basic tool an investor uses to analyse a company. The tools of fundamental analysis are easy for an average investor to learn, and can be mastered easily with some efforts.  This chapter discusses some of the more important tools. These tools should suffice most of your practical requirements and you need not go beyond them. We are against using intricate mathematics for stock market analysis. Some of the tools loaded with intricate mathematics are so heavy that they lose their practical relevance. Anything that uses advanced mathematical formulae with complex equations requiring a scientific calculator or a computer program to compute is to be looked upon with suspicion. As we discussed in the chapter of financial statements, accounting is common sense reduction of business transactions into figures meant to be understood by actual users of those figures. ٰ If you have understood the basic financial statements and how to read them, analysing them is just one more step forward. The primary took for such analysis is ratio analysis. Spend some time understanding key accounting ratios, and you will thank me for the rest of your life for giving you one of the most important tools of stock analysis.

We must begin the discussion on accounting ratios with a word of caution. No single ratio can give the complete picture; study of a combination of ratios will always make the analysis meaningful. Never get excited if you find a stock undervalued based on just one ratio: that should be the starting point of your investigation, not the final conclusion. Ratios should be handled with care, business is not precise mathematics, and so business analysis is also not amenable to exact mathematical model. Any attempt to treat it so is hazardous. Many a time you need to travel beyond mathematics and accounting to corroborate your findings.

The starting point of any meaningful analysis of the fundamentals of a company is the P/E ratio. P/E ratio is a quick test to find out if a stock is overvalued or undervalued compared to its earnings. Let us understand the concept.

 

P/E ratio is the ratio between market price of a share and its earnings. Before we proceed to understand the equation, let us calculate earnings per share (EPS). We saw earlier that profit and loss account is a statement that shows you how much profit the company has earned. The net profit of the company, after providing for all expenses, and taxes is the amount that belongs to the shareholders of the company. Part of the amount may be distributed as dividends and the remaining may be ploughed back in business by the company. The amount of profit, before distribution of dividends is the earning we are concerned about, as shareholders of the company. For the sake of example, let us take that company A earned Rs 1 crore after taxes. Another company let us call it company B has earned Rs 5 crores during the same period. Can you conclude that company B is better than company A? No, because you don’t know the size of the companies. Company A might have made the profits of Rs 1 crore on a capital investment of Rs 5 crores, whereas the company B might have made the profits of Rs 5 crores on a capital investment of Rs 50 crores. Comparing the profits of these two companies will be comparing apples to oranges. In order that comparison is meaningful, you may find out earning per share. To keep the example simple, let us say, both companies have their capital divided into shares of Rs 100 each; company A has issued 10,00,000 shares of Rs 100 each totalling to Rs 1 crores, while company B has issued 50 lakh shares of Rs 100 each totalling to Rs. 50 crores. Now we use this information to find earning per share. Earnings per share is simply total earning divided by the number of shares.

The EPS of company A is Rs 1 crore divided by 10 lakh shares

 

100,00,000/10,00,000 = Rs 10.

 

Simply stated, per share earnings of company A is Rs 10, or the company earns Rs 10 on each share it has issued.

 

Now let us calculate the EPS of company B:

 

5 crores divided by 50 lakhs

5,00,00,000/50,00,000 = Rs 10 per share.

 

 

The EPS of both the companies is same at Rs 10 per share. The figures suddenly start making sense. They are no longer a comparison between apples and oranges. They are comparable. What looked like entirely different earning figures turned out to be the same figures per share.

 

Thus EPS is earning per share and is useful for comparing earnings across companies, or periods. Note that the issue price of a share could be different for different companies. In India you may usually find shares issued for Rs 100, Rs 10 or sometimes Re 1 (occurring because of stock splits) , in order for the EPS to be meaningful you should also know the par value of shares.

Now we take this analysis to the next level and link it with the market price of the share. We presume our company A is selling at Rs 250 per share. The price earnings ratio will be:

 

Current Price / EPS

 

Rs 250 / Rs 10 = 25

 

Assume that company B’s latest price quote is Rs 400. The P/E ratio of Company B will be

 

Rs. 400 / Rs 10 = 40

 

This ratio is almost a magical number for investors. The ratio can also be understood as a number or a multiple:  price is 25 times the earnings.

What does it mean? In simplest terms-though life does not exist in this simple form-it means that if an investor were to buy one share of A at the present market price of Rs 250, at the PE multiple of 25, it will take him 25 years to get his money back. This is a simplistic criterion; receiving Rs 10 every year for 25 years will make it a total of Rs 250. It is presuming linearity of earnings, that earnings will not grow in future, it is also ignoring time value of money, 25 years from now Rs 10 would be worth much less. Still it acts as a great rule of thumb, not as an absolute measure but perhaps as a means of inter-firm comparison, or comparison with industry data, or even comparison arose industries. The P/E multiple makes the statistics of price and earnings portable and logical.

Conclusions are easy to draw now. Other things being equal, will you be investing in A or B? While A will give your money back in 25 years, B will give it back in 40 years. In comparison to B, A is undervalued; or to put it in other words, in comparison to A, B is overvalued.

However there is more to P/E than meets the eyes. What if the company B is growing at a rate faster than the rate of growth of A? The future earnings of B will soon be higher than that of A, does that not justify higher PE multiple?

Based on this discussion, we can draw two important principles:

  1. In general stocks with lower PE multiple are undervalued in comparison to stocks with higher PE.
  2. The market assigns higher PE multiple to future growth. A company growing at a higher rate will trade at a higher PE multiple. It is not unusual to estimate future earnings for next 2-3 years, and calculate future PE multiple.

 

Don’t these two like diametrically opposite conclusions from the same ratio? They do and they are. That is the reason I cautioned you in the beginning that drawing conclusions from one single ratio in isolation can be dangerous. You may end up buying a stock with low PE because it is in a failing business and its future earnings are going to be low.

The PE is not without its drawbacks and it is very important that you know the limitations of the tool you are using.

In isolation PE ratio has no meaning. A PE ratio of 12 means nothing about the valuation of a company, unless you compare it to the peers or the industry average. The biggest defect in the whole schema is that the benchmark itself shifts when the market gets overheated. Keep in mind that if a stock has a lower PE ratio than the industry, that fact alone does not make it cheaper. The industry PE may itself have become expensive, so at the most one might say that the stock is cheaper than the industry, but may still be expensive per se.

Recollect the dot-com mania where the industry PE was as high as 200! A stock with a PE multiple of 80 would have looked cheaper in comparison, and people made the mistake of buying those shares. In the case of many companies the denominator E was a negative, the company was in red, yet there was more demand than supply. When there is frenzy in the market, logic is the first casualty. Some people even argued that the conventional accounting ratios are dead in the dot-com era, ‘eyeballs’ and ‘hits’ on websites was all that mattered. Until the bubble bursts.

While PE is a great quick indicator, don’t trust it fully until you are confident that ‘E’ is clean. Sometimes the figure of earning may mislead. Consider a particular year when the company has sold off a part of business, the ‘capital gains’ will also reflect in the EPS, making it look better than what it is. Since we are using PE to find out long term growth prospects of the company, such one off transactions might distort the results. Unscrupulous managements often resort to extraordinary items to boost up the EPS. You need to filter unusual items off to get the EPS that comes from the usual business operations of the company. The best way to detect unusual items distorting the EPS is to look into the cash flow statements to know the sources where the cash came from. Occasionally the EPS may be depressed because of an extraordinary loss booked by the company during that year. The company might have commissioned a massive plant, which though operational has not contributed much to the revenue in the first year, but the expenses and depreciation have been charged to the account, leading to a lower than usual EPS for the year. This can be a great investment opportunity, since those who consider PE ratio to be sacrosanct might not probe deeper to find out the distortion. The key, again, is to look into the cash flow statement.

Certain businesses are cyclical in nature, and the EPS would depend upon what part of the cycle it is presently operating in. Thus a steel company when it is at the top of trade cycle will have earnings that are higher than that at the lower part. If you make a long term decision based on one year’s performance, it may give unpredictable results. A better course will be to take an average of EPS of one full cycle, ad use that to judge. But a cycle may last 8 years, so the parameter will remain only for a long term investor.

As PE ratio became the most popular indicator, analysts started experimenting with refinements. It is not unusual to equate current price against previous period earning; and also to equate current price with a future period earning estimate. When the stocks become expensive, analysts try to justify it by replacing the ‘E’ with a notional ‘E’, the estimated future earnings. This is entering the danger zone and one need to tread with caution. It is because future is uncertain that we are using indicators like PE to find relative margin of safety. Quantifying the future in exact mathematical terms, when one of the factors (the denominator) is an estimate is fraught with danger.

High inflation is another factor that may distort the efficacy of PE ratio as a consistent tool. When the inflation is high, the replacement cost of equipments and inventory is higher, when a machine purchased for Rs 10 lakhs wears out the replacement machinery may come at a much higher price, but the depreciation charged in accounts is based on the historical cost of machinery. To put in other words, the value of money in one year is not comparable to that in another year, making comparison inaccurate.

To sum up

  1. PE ratio is arrived at by dividing the current market price by the earnings per share.
  2. Variations exist in terms of the trailing PE, current PE, and the forward PE.
  3. Historically the average PE ratio of the market has been around 15-20.
  4. Theoretically speaking, PE tells how much an investor is willing to pay per rupee of earnings.
  5. Another interpretation of a PE ratio could be a reflection of the market expectations about a company’s prospects.
  6. PE in isolation is meaningless; it needs to be used with other ratios.
  7. PE in isolation is meaningless; it is useful in comparison with industry PE or peers’ PE.
  8. Industry PE is an unreliable benchmark, a stock with lower PE than industry average may be cheaper, but not cheap.
  9. PE ratios are generally lower during periods of higher inflation.

©Dr. Tejinder Singh Rawal

Chartered Accountant

M. Com, MA (Economics), MA (Public Administration), MA (Urdu), LLB, FCA, ISA, CISA, CISM, PhD

This content is copyrighted and no part of it may be reproduced without the consent of the author

 This discussion will be a part of the forthcoming book by me “The Smart Long Term Investor: Common Sense Strategies for Wealth Creation” Suggestions are welcome and will be appreciated

 

 

 

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