Simple Yet Revealing : P/E Ratio

Most people currently invested or trading in stocks know what a P/E ratio is. Simply put, it's Market Price of a Share/Earning per Share or EPS. For those of you who don't know what EPS is, it's calculated by dividing the total number of shares of that company from its Net Earnings. Now for example if P/E ratio of a stock is 24.5 then this means that on an earning per share of 10 rupees the buyer is ready to pay 245 rupees. So 24.5 is 245 which is the stock price divided by 10 which is EPS. Simple! Right. But wait there's more.

 

 

Broadly P/E helps an investor take decision, on whether a share is expensive or cheap. General thumb rule followed by all is, a Lower P/E ratio implies that the stock is cheap/ undervalued and higher P/E ratio means that the stock is expensive/ overvalued. At the same time investors are willing to pay a huge premium to buy it which tells us the investor's confidence in that company. Now keep in mind that these numbers are relative to the other competitors in that industry.

 

 

Take for example the IT industry, consisting of tech giants like TCS & Infosys. P/E of TCS is 23.49 and that of Infosys is 20.05 as of June 2020. From these figures I can say that I'm getting Infosys at a more discounted rate as compared to TCS due to its cheaper PE. But there's more to it than meets the eye. Just because P/E of one company is cheaper than the other doesn't mean that the stock is valued at a bargain. There can be a lot of factors as to why it might appear cheaper than its competitors like for example a bad news which temporarily crashes the stock price or fluctuations in EPS.

 

 

Now I'll let you in on a secret, a secret which is unheard by many. Let's start with a hypothetical case consisting of 2 companies, A & B. Assuming that Share price of A is 1000 whereas that of B is 2000 and Current Earnings of both the companies is 100cr. From here i can say that current P/E of A is 10 whereas that of B is 20. Now in general sense, most people would go for company A as it's P/E ratio is less in comparison, add to that its earnings is same as that of B. But without knowing the full reason as to why A is cheaper we cannot ascertain for sure that buying stocks of company A would be a value decision.

 

 

Let's see what I'm trying to imply by checking the past 2 year history of both Companies. In the first year company A made a profit of 80cr, whereas B was at 20cr. Second year A made a profit of 90cr and B was at 50cr and in the third year both Companies netted a profit of 100cr.

 

 

What most people see here is, Hey!! A has more earnings than B, but what I'll tell you to see is Hey!! Look at the rate at which the profit margins of B are growing. In just 3 years it caught up to A considering it had significantly less earnings in the first year. Company A has a slow earnings growth compared to Company B in past 3 years so I as an investor expect company A to grow at this rate in the near future. Now coming to B, it is growing at much faster rate when compared to A, and in future too this growth rate is expected which tells me that investors are optimistic about this company because of its higher P/E and double the share price of A.

 

 

Many people use the past or the trailing P/E to make investment decisions whereas Smart Investors use the future or the projected P/E to analyze the stock and this gives them a better insight on how a company will perform in the coming future. So in a nutshell, cheaper projected P/E will be the top choice among smart investors due to which its current stock price will increase thus placing it at a premium valuation.

 

 

Also, if a company is increasing its EPS at a fast rate like the company B in above example, its P/E can fall. Though it never happens because the share price appreciates which keeps the P/E steady. But the price at which you brought the share, when divided by the increased EPS will make the P/E less, implying that the expensive price at which you bought the share is no longer expensive. It's cheap.

 

 

The stock price appreciates because investors like you are also willing to buy that stock at a higher valuation, so what you basically did was buy low and sell high....that is if you want to sell. Frankly, as an investor I won't care about the high P/E knowing that the company will grow at a really fast rate like it's previous track record.

 

 

Sometimes P/E ratio can also deceive you. So in cyclical sector like real estate or sugar industry, due to seasoned earnings, one cannot correctly judge the company based on P/E as 1 year their EPS might increase 10 fold thus reducing the P/E and the next year it could fall by 50 %, leading to a more expensive valuation.

 

 

So maybe buying these companies when their EPS has fallen will be better, knowing that their earnings will be better in the future, but that's not a method I would recommend. A better judge here would be the Price to Book ratio which I will leave for a later discussion as for now you guys have had enough.

 

Note : All images used in this post has been taken from Google Images and the copyright of each of the images lies with their copyright holders.

 

 

The views expressed above are personal and belong to the author.

This post has been written by Somaditya Singh.

Also See : Return on Equity