If you follow the stock market, you will often hear statements like, the market is over-valued or under-valued, this stock is expensive and that stock is cheap etc. What does over-valued or under-valued, expensive or cheap mean in the context of stocks? In the last few days and weeks, there has been a lot of talk on whether the Indian market (Nifty) is stretched in terms of valuation. We will touch on this topic in this blog post. If share price of Company A is Rs 1,000 and that of Company B is Rs 50, it does not mean that Company A is more expensive than Company B. Share prices always have to be seen in context of the earnings per share (EPS).
EPS is the Profit after Tax (PAT) divided by the total number of shares outstanding. EPS, in effect, is the profit for the shareholder after paying for all business related costs, lenders and the Government (tax). Investors should understand that EPS belongs to the shareholder (investor). The management has the discretion of paying a portion of the EPS to shareholders as dividends (after paying dividend distribution tax) and ploughing the rest back in the business for future growth. When you are buying shares of a company, you are essentially buying the future earnings per share of the company. If the EPS is high, you will be ready to pay a higher price and if it is not high, then you will not be ready to pay a high price.
Price Earnings or P/E ratio is the price the investor has to pay to buy Rs 1 of EPS of a stock. Mathematically, P/E ratio is the ratio of the current share price divided by the EPS. In financial journals and portals, you will find reference to two types of P/E ratios:-
A high P/E ratio means that a stock is expensive and a low P/E ratio means that a stock is less expensive (cheap). Readers should understand that, high and low here are relative concepts. For example, the P/E ratio of a leading automobile company is around 28, while that of a leading pharmaceuticals company is 20. Does it mean that, the automobile company is expensive and the pharma company is cheap? No. Different industry sectors have different growth potential and consequently, investor EPS expectations differ from sector to sector. Even within a broad industry sector, different sub-sectors may have different EPS growth expectations, for example, within the automobile sector there may different EPS growth expectations for a car manufacturer and a motorcycle manufacturer. You can, however, compare P/E ratios of two companies with similar businesses and growth prospects. You can get higher returns by investing in the cheaper company and avoiding the more expensive company.
Previously in our blog, we have discussed about two investing styles - growth and value investing. In growth investing, investors and fund managers like to invest in growth stocks, i.e. stocks which are likely to deliver high EPS growth in the coming quarters and years. In value investing, investors and fund managers like to invest in value stocks, i.e. stocks which are priced at a considerable discount to its fair (fundamental value), in other words, low P/E ratio.
Typically growth stocks have high P/E ratios, because investors are expecting high EPS growth and hence are ready to pay more for the shares. If the companies are able to meet / exceed the earnings expectations of growth investors, expectations are raised even further and reflected in the price, giving high returns to investors. The problem with such stocks, however, is that, they tend to get over-heated and therefore, suffer more in market corrections / bear markets. Value stocks have low P/E ratios, because the future EPS growth is mispriced by the market. While value stocks can give even better returns than growth stocks, value investors should remember that, P/E re-rating may take time and therefore, they have to be patient. Value stocks tend to do well across different market cycles because the downside potential is lower in such stocks.
A third investing style, known as Growth at a Reasonable Price (GARP), as the name suggests, combines aspects of growth and value investing. In GARP investment style is a variant of P/E ratio, PEG ratio, is widely used to make investment decisions. PEG ratio of a stock is P/E ratio divided by annual EPS growth. Using PEG ratio the fund manager factors in the valuation (P/E ratio) and also the EPS growth. A stock with high PEG means that, the valuation (P/E ratio) is too high relative to earnings growth and vice versa. Fund managers employing GARP, likes stocks which have relatively low P/E ratios and relatively high EPS growth.
We have already discussed that high P/E ratio does not necessarily mean you will get low returns in the future similarly low P/E ratio does not mean that, you will get extraordinary returns in the next few months. P/E ratio is just one of the tools available in your arsenal to select stocks depending on your investment objectives.
Besides, there are several limitations of P/E ratios. Let us discuss some accounting limitations first. In an inflationary environment, like we have in India, companies with large inventory are likely to outperform in terms of operating margin. This is will cause P/E ratio to be lower because EPS will be higher, but investors should note that, this is purely due to timing and not sustainable because the future cost of raw materials and inventory will be higher.
Similarly, in an inflationary environment, a company which has significant amount of depreciation in its books will have a lower P/E ratio, especially as plant and machinery approach the end of their useful lives and need replacement in the short term future. Again the lower P/E ratio is not sustainable because the cost will shoot up when plant and machinery have to be replaced, resulting in lower EPS in the future.
If a company has large amount of (relatively new) debt in its balance sheet, the P/E ratio is likely to be high because of high interest expenses and consequently, lower EPS. While I, personally, do not like companies with high debt equity ratios, many capital intensive companies with good management teams and business models, are able to deploy debt capital very efficiently for business growth. While high debt equity ratio may initially result in high P/E ratio, if companies get good return on investment of debt capital, it will result in good earnings growth and returns for investors.
Finally, just because the P/E ratio of a company is very low, it does not automatically make it an attractive buy. Market may misprice stocks from time to time, but we have to remember that, the market represents the collective wisdom of all the investors in the marketplace. A company’s P/E ratio may be low, because the market is worried about the growth potential of the company or even the prospects of a financial distress in the future.
By P/E ratio of the market, we mean the P/E ratio of the major stock indices. I personally follow the Nifty, so will discuss about P/E ratio of the Nifty but the same discussion can be extended to any market index. P/E ratio of Nifty is the Nifty value divided by the weighted average (Nifty weights) earnings per share of the 50 companies in the index. The P/E ratio of Nifty is around 23, as on April 19, 2017. One year back the P/E ratio of Nifty was 22. So, in the last one year Nifty has certainly become more expensive but only slightly. Two years back (April 2015) the P/E ratio of Nifty was around 23 (same as it is now). As some readers will know, Nifty fell by more than 20% in 2015 -16. Hopefully, you understand why some experts are worried about Nifty valuations.
Will history repeat itself? No one can predict the future. If we look at Nifty valuations between April 19, 2016 (P/E ratio of 22) and April 19, 2017 (P/E ratio of 23), the P/E expansion was around 5%. In the last one year Nifty has given 15% return; this could not have been possible simply due to P/E expansion (read optimistic sentiments), there was also actual earnings growth. Therefore, the FY 2016 – 2017 quarterly earnings will be very important in forming market sentiments. The earnings season has just begun and it is too early to make any judgement. Investors should follow the earnings season along with other major developments, if they want to get a sense of market sentiments in the coming months or quarters.
In this blog post, we discussed about P/E ratio, how it is calculated, how it is used, its relevance to various investment strategies and its limitations. P/E ratio is a great metric for stock valuation, but it has to be used in conjunction with various other decision factors like business model evaluation, analysis of the competition in the market, critical evaluation of management quality, balance sheet analysis etc. We also discussed Nifty valuations in this post. We refrained from commenting, whether Nifty is over-valued or under-valued or fairly valued. We hear different market voices; some say it is over-valued, while others say, it is just about fairly valued. It may be worthwhile studying valuations of Nifty and returns at different points of time in history, but that is topic of another post. Please stay tuned........
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