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6 things they don’t tell you about the PE ratio

October 26, 2020

For those of you who are new to stock investing, price earnings ratio or PE ratio or PE multiple may seem like ‘THE METRIC’ to choose stocks. A few weeks ago, a young candidate I was interviewing excitedly showed me his stock list. He said these were all ‘low P/E stocks’ and he had run some screeners on few other metrics as well and short-listed them. He was convinced that they were going to be multi-baggers given their steep discount to the rest of the market.

My only question was – why didn’t others discover these stocks? This is a question I learnt to ask myself from 2 decades ago, when I entered stocks and went merely by stock valuations.

If you are a new investor, running screeners through equity apps to pick your stocks, here’s what you need to know about the PE ratio.

Note that this article will be useful for beginners and even interesting for those who know about stock investing a bit. If you are a pro, I have no qualms in suggesting that you instead (or in addition) read a blog by Prof. Aswath Damodaran (of the Stern School of Business, NYU) on his rules for the PE road! Questions on that? Please ask the Prof. 😊

#1 Which ‘E’ for the PE?

The price earnings or PE multiple is the price of a stock measured as a multiple of the earnings per share of the company. In other words, it is the multiple on a company’s earnings that you are willing to pay, to buy the stock today.

To define it, P/E ratio = Market price of the share of a company/Earnings per share. The earnings can be trailing 4 quarters or annualized or even the expected per share earnings (forward valuation). The price you pay is for the future earnings, even if you consider the trailing earnings as a valuation point.

So, when you look at various reports and in websites, you will, with time, realize that there is no uniformity in the way the PE multiple is stated. Some take the trailing earnings; some take the annualized earnings for the fiscal and some give out an analyst consensus estimate.

Similarly, the earnings may be standalone at times (when new subsidiaries formed are loss making). At other times, the standalone may make little sense if it is merely a holding company and derives its entire income from subsidiary and group companies. And then there may be companies that are large themselves (take SBI) and yet derive a significant portion from their subsidiaries.

Unless you know this distinction, PEs will add little value to your decisions when you merely run screeners without understanding the nature of the business. These factors may change your perspective of whether a company is cheap or expensive.

Another simple yet deceptive case is when the earnings get diluted because of significant infusion of capital. At such times, the capital infusion will dent the per share earnings and inflate the PE. And yet, when the capital is put to use, the forward earnings may be far higher. Hence, historical earnings may deceive you in this case.

#2 You don’t pay only for growth

If you are among those investors trying to master equity investing through the many online stock market crash courses, you would have heard this for sure: ‘If a stock is trading at a PE of 25 times, do you expect the company’s earnings to grow by 25%?’ Logical as it may seem, this question does not adequately answer the reason for a stock trading at a certain PE.  This is because PE is influenced by many factors other than growth too. Let’s understand some of them.

In times when the return on equity is dented (like it was between 2010-2020), investors will readily pay a higher price for superior return on equity. In times of poor credit worthiness, the market pays a premium for low debt and cash rich companies. And, in times when growth is hard to come by, market respects regular dividend payouts.

 All of these will make the PE multiple seem at a premium. So, in these instances, it is not just the growth in ‘E’ that determined the price. There are other factors. This is the reason why you would have seen companies with an already ‘high’ PE moving to ‘higher PE’ territories after you believed it would correct.

Let us take 2 examples of FMCG companies – Dabur India and Britannia Industries. Dabur India was trading at 54 times PE at the beginning of the year. It was by no means cheap. If you asked yourself whether the company would deliver an earnings growth of 54% in the next 2-3 years, the answer would have been a no. In fact, the company’s earnings did not grow last fiscal.

But its stock returned 13.2% year to date and is now trading at 63 times trailing earnings. Its return is head and shoulders over the Nifty 50. Clearly it was not the ‘growth’ for which the market afforded it a further premium.

The high PE was awarded for other factors such as its high ROE, low debt, steady if not high dividend payouts.

Now, take Britannia India. The stock was trading at 58 times PE at the beginning of this calendar. Not cheap at all, you would have thought. But little would you have expected the stock to more than double its June quarter earnings over a year ago; followed by another strong quarter in September 2020. The result? The stock rallied by 12.2% year to date and PE has come down to 46 times.

Do you see your takeaways in both the above cases? In the case of Dabur India, there was no growth, and you did not expect that the market would value the stock for other reasons. In the second case of Britannia, the trailing PE seemed expensive but you may not have deduced that the PE would correct and the stock deliver, buttressed by sound earnings growth – unless of course you did foresee such an outstanding growth!

In the case of Dabur India, we spoke of a re-rating of PE. But the converse is also true. A highly regulation driven sector (like say oil marketing or fertilizer) may not receive high valuation. Similarly, the market may show reluctance to pay a premium in the face of high cyclicality in businesses.

#3 PEs change as a sector evolves (or when you get a better grip!)

Stock markets also struggle to value new-fangled ideas and fanciful themes initially. This may result in these sectors getting overestimated initially. With time, when markets realize that there are better metrics to value these segments, the sector/theme gets re-rated or de-rated.

Real estate, infrastructure, retailing and media pre-2008 all enjoyed a high PE multiple but have never gone back to those levels in the past decade. For infrastructure companies with road projects, order book was a big boost. Any PE was justified if the order book was multiple times revenue. But what if the order did not get executed on time? That happened. Markets learnt it the hard way. Road plays were valued on the revenue they brought from their annuity/toll income than the orders in hand. Their PEs too corrected.

Another classic example is real estate. Real estate play DLF, for instance, enjoyed a PE multiple of over 50 post its listing, going up to even 100 times. It is now at a more modest 27 times median PE in the last 3 years. Once the markets got a grip that earnings growth in real estate was not a mere function of the land bank, the PEs automatically readjusted to lower levels. A similar story played out with IT companies post Y2K and with retailing between 2006-08. And it likely that the same is playing out with select segments in the financial space now. For example, you would have seen the decline in PE valuations of asset management companies in the past one year.

Paying a high valuation for these newbies when you enter them too early may sometimes mean less money on the table or even worse, losses – unless you know how to quickly exit them. Their PE multiples won’t offer cues there.  

#4 PEs can signal the other way round

Sometimes you will also have to turn the real nature of PE on its head when you interpret it for some sectors. When your screener throws a commodity company with a very low PE multiple, you might think that you have a gem. But chances are that its earnings have peaked. Yes, unlike other sectors, market is wise enough to recognize when the commodity cycle is over. The prices don’t shoot up perennially as earnings rise.

Markets recognize that the commodity may be entering a downturn and may not deliver returns. Similarly, when the valuation shoots up, it may well mean that earnings are terrible now but are going to pick pace. This is often seen in sectors such as sugar, metals and other commodities that are inputs for many industries. Hence, if you didn’t know the sector cycles, you can be taking wrong decisions based on PE.

#5 PEs change with interest rate cycles

Have you been wondering why the Nifty PE ratio has been high for several years now? Go check our historical chart on the Nifty PE ratio (as given by NSE) and you will see that in the past 5 years the Nifty PE hardly went below 20. If you thought the Nifty was trading above its average PE and remained on the sidelines, you would have missed on sound rallies in a majority of stocks. But then weren’t you taught about mean reversion? And that high valuations can’t remain high for long? So, what happened? Interest rates changed.

When the risk-free rate is low, the discounting leads to a higher valued asset. Hence, in a low interest scenario, you will find fewer stocks with a low PE multiple. Not knowing this may mean that you miss an entire opportunity or ill-time your entry.

Interest rate scenarios too influence PE multiples. When you use the long-route to stock valuation (discounted cash flow), you will know that the underlying value of a company is simply the sum of its future business cash flows in today’s value (discounted at a risk-free rate). When the risk-free rate is low, the discounting leads to a higher valued asset. Hence, in a low interest scenario, you will find fewer stocks with a low PE multiple (as is the case now). But not knowing the impact of rate cycles on markets, you may believe that there is no opportunity.

Now combine the scenarios of low interest rate, poor growth, poor credit quality and poor return on capital. That gives you only a few companies that the market chose to hold – at high PEs – because these companies were better than the rest on some of these factors, even when growth isn’t great! And this, analysts, and fund managers term as polarization of market.

#6 PEs can tell you any story you wish to tell! 

Are you one of those investors who closely track brokerage reports for their ‘underweight’ and ‘overweight’ calls? Did you notice how a same stock sometimes has a ‘buy’ call by one brokerage and ‘sell’ call by another at the same time? (as an aside – unlike MFs, please remember brokerages make money whether you buy or sell)

This is simply because PEs lend themselves to different interpretations, based on how you calculate the PE. For example, in a bullish market, you will see most analysts going only by the forward PE. This will of course be lower than the current PE as they project earnings growth. A forward PE will naturally distract you from the fact that the current PE is very high. But at the same time, if one wants to issue a sell call (easier when the rally loses steam), it is easy to quote the current PE to say how the PE is not justified vis-à-vis the company’s growth prospects.

So which call do you follow then? No, I am not going to pitch for our upcoming equity recommendation product 😀 We will certainly have our hits and misses there!

Instead, let me say this:

To do well in the world of stock market investing,

  • You will need to be able to use screeners effectively to short list your stocks,
  • You will need to be able to interpret financial data, including ratios, in the right way, and
  • You will need to really understand the business of the company that you are seeking to invest in.

Only when you do all these, will you be able to choose correctly and invest confidently. We do hope to help you with these soon – see you there!

Use our Nifty 50 heat map to get a market snapshot of the last 20 years.

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