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The P/E enigma |
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By Harendra Kumar |
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| One of the cardinal principles of stock investing
is ‘Buy low and sell high’. The essence is to time
your buy. To make money in a bear market, just buying and waiting
isn't enough. You must buy only 'cheap' stocks. But when is
a stock cheap? Most investors would be influenced by the profit
of a company. Earnings, however, alone mean absolutely nothing.
In order to get a sense of how expensive or cheap a stock is,
you have to look at earnings relative to the stock price and
hence employ the P/E ratio or the price-to-earnings ratio. |
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| Widely used by investors the world over, the
P/E ratio indicates the value of a stock in relation to the
company's earnings. The P/E ratio of a company is computed by
dividing its share price with its latest earnings per share
(EPS), which, in turn, is the net profit divided by the number
of outstanding shares. |
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| A high P/E ratio suggests the stock is in
great demand, or that the company has bright growth prospects
or competitive advantages. |
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Conceptually the P/E multiple represents the
premium that the market is willing to pay on the earnings based
on its future growth. The ratio is most often used to conclude
whether a stock is undervalued or overvalued. In effect, the
ratio uses the company's earnings as a guide to value it. The
P/E thus computed is also known as the trailing or historical
P/E since it uses the trailing (historical) EPS in its calculations.
A variant of the P/E - called the forward P/E - has also been
developed wherein the current market price of the stock is divided
by the expected future EPS. The attempt to study P/E ratios
in this manner reflects the effort to factor in the expected
growth of a company. |
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| A stock isn't necessarily cheap when it has
a low price-earnings (PE) multiple, though PE is a useful parameter.
A high-growth company may be cheap even at very high PE multiples.
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If ABC Ltd were currently trading at Rs 20
a share with Rs 4 of earnings per share (EPS), it would have
a P/E of 5. Big increase in earnings is an important factor
for share value appreciation. When a stock's P/E ratio is high;
the majority of investors consider it as pricey or overvalued.
Stocks with low P/E's are typically considered a good value.
However, studies done and past market experience have proved
that the higher the P/E the better the stock.
The P/E multiple varies from stock to stock based on the market
perception. Consider a hypothetical example of ABC and XYZ which
are quoting at about Rs 2,500 (a P/E of 49) and Rs 7,800 (a
P/E of 180), respectively, based on historical earnings. Based
solely on the market prices, XYZ looks almost three times more
expensive then ABC. Why should the market be willing to pay
180 times earnings for XYZ and 49 times earnings in the case
of ABC?
ABC has shown a steady growth of about 20 per cent in net profits
for the past few years while XYZ has shown a growth of 100 per
cent in net profits. |
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| Now if we work out the forward P/Es for both
the stocks, assuming similar growth rates for the next year,
the forward P/E of ABC works out to 40.83 and that of XYZ is
90. The gap between the two P/Es would further come down as
a longer time horizon is taken into consideration. Hence, ABC
and XYZ attract different valuations based on the expected earnings
growth rates. |
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| However, one should never make a stock decision
solely on the basis of the P/E ratio. Always read the P/E ratio
along with various quantitative and qualitative factors that
impact the company. First, one can obtain some idea of a reasonable
price to pay for the stock by comparing its present P/E to its
past levels of P/E ratio. One can learn what is a high and what
is a low P/E for the individual company. One can compare the
P/E ratio of the company with that of the market giving a relative
measure. One can also use the average P/E ratio over time to
help judge the reasonableness of the present levels of prices. |
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All this suggests that as an investor one
has to attempt to purchase a stock close to what is judged as
a reasonable P/E ratio based on the comparisons made. One must
also realize that you have to pay a higher price for a quality
company with quality management and attractive earnings potential.
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