The PE ratio is the most common tool used by investors and financial analysts to determine how expensive or how cheap a stock is. Unfortunately, it is also one of the most misunderstood tools in the investment business. A stock which may be having a PE of 5 may be thought to be cheap and yet it may turn out to be quite an expensive mistake. Similarly, a stock which may be having a PE of 100 may thought to be too expensive may actually turn out to be a bargain.Sometimes it may happen that a stock may be trading at a PE of 2 or 3 and it may look cheap in terms of valuation, but an investor should not jump to conclusion so quickly, as the reason for high earning could be sale of some asset or some notional gain from fluctuations in foreign exchange. These kind of earnings are non-recurring in nature and for determining PE ratio, only the income from operating activities should be looked into. An investor while analyzing a script should always pay attention to "Notes on accounts" as it tells a lot about the income of the company.
Similarly a company which has no operations as of today and is working on a project which may reap benefits in the near future, may trade at a PE of 50 on account of minuscule earnings from its investments in mutual funds or dividends. It may look expensive at present, but it's future stream of income can be so high that even a PE of 50 can turn out to be a bargain.
What are the determinants of a stock's PE ratio? Let's have a look at them
Stability
Stable earning power is worth more than volatile earning power. The more stable and predictable the earnings, the higher will be the PE ratio, other things remaining unchanged. Markets do not like unpleasant surprises. They love companies which can grow their earnings in a stable, predictable way. Such companies are rewarded by markets by making their stocks sell at relatively high PE multiples as compared to stocks of cyclical companies. Never expect a cyclical stock to sell at a very high PE multiple.
Growth
Growing earnings are worth more than non growing earnings. Assume that you are offered to pay a lump-sum of money in exchange of a promise to receive ten thousand rupees a year forever and ever and on the other hand another person offered you to again pay a lump-sum of money, but this time your earning stream would start at ten thousand but would grow at 5% p.a. Obviously you will pay a higher lump-sum amount in the second case in comparison to the first case because in the second case you have been assured of a growing earning stream, which is a more lucrative offer in comparison to the offer made by the first person.
But, an investor should always be cautious while predicting future earning stream of a company, because in case of a business nothing can be assured. During the year 2000, the IT industry was at its peak and everyone thought that their business could grow endlessly. People were willing to pay just about any price to get a pie of a company like Infosys or Wipro. At that time the two stocks used to trade at a PE of 80-100. A PE of 80-100 means, that if a company maintains the same level of earnings and pays back all in the form of dividend, then it would take 80-100 years to recover the money invested.
Now, if we take the actual scenario where Infosys was registering a growth of about 20-25% YOY, then also the simple mathematics of compound interest tells you, that for recovering the total amount paid at a PE of 100 would take approximately 20.5 years. No company of a size of Infosys or even smaller can grow at a rate of about 25% for 20 years on a trot, as competition and reduction in opportunities won't let the company grow at the same rate or higher.
We all know what happened after wards as most of the IT industry stocks are languishing or have not attained the same levels again, so it's better to avoid following the heard, and some rationality should be there while paying a price for high-growth company as market's expectation about future growth are already discounted by the high PE multiple. If earnings growth were to slow down, then the PE multiple could decline quite rapidly.
Dividends
Generally speaking markets tend to be wary of companies which retain much of their earnings instead of paying them out as dividends. People want companies to actually pay out some part of the earnings as dividend, as it builds up trust in the minds of the investor about the management and their wealth sharing attitude.
Return on Invested Capital
Stocks of companies which earn high returns on their invested capital and are expected to do so in the future tend to command high PE ratios. The important point to note here is that the relationship between the return on invested capital and PE ratios is not linear. If a company earns 15% return on its invested capital and rationally sells at a PE of 15, this does not mean that a company which earns a 25% return on its invested capital should sell at a PE of 25. This is because the second company is compounding its shareholders funds at a much faster pace than the first company.
Leverage
Some companies have large amount of debts in their books, even more than the total shareholder's wealth. Large value of debt in comparison to the total value of assets of the company can be detrimental to the health of the company in terms of large amount of interest payments. Investors rightly perceive these companies as risky and therefore they sell at a lower PE in comparison to that of a debt-free or low-debt companies.
Some debt is good as it helps avoid equity dilution, but large-debt company, say with a debt/equity ratio of greater than 1.5 should be avoided on all grounds.
Quality of Management
Some companies command a higher PE than their peers in the same sector and that's largely because of the quality of management and the leaders leading the company. Someone like Mr. Narayanmurthy or Mr. Sunil Mittal are held in high esteem by the financial community, because of their ability to draw better margins out of the same business and also because of the level of corporate governance that they maintain.
Interest Rates
The final factor affecting PE ratios is the factor of interest rates. When interest rates fall, then people lose their interest in fixed deposit schemes, because of the decrease in the value of the perpetual income stream. Thus, sensing a better opportunity in equities market, people divert their savings from fixed income securities market to the equities and this increase in pumping of money results into higher PE multiples for stocks.
Also, when interest rates rise, people start taking into account security of their capital, and there's a slight outflow of money from the equities, which results into lowering of PE as a whole.
To contact the Lead associate on this story: Ekansh Mittal in Noida (New Delhi) at Ekansh@hbjcapital.com
