Perils of treading the PE path

Investors must understand the business, cash flows and risks before valuing a stock

Last week, I was interviewing a fresher. His enthusiasm for stock markets was infectious. He excitedly opened his mobile to show me the list of stocks he had filtered using online financial screeners.

He was going to start investing in, what he thought were, stocks that the rest of the market had not ‘discovered.’ And at prices that he thought were true ‘value.’ Not surprisingly, I found many of his low PE stocks were value traps or worthless.

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

PE ratio is nothing but the measure of the price of a company’s stock as a multiple of the earnings that a company generates/seeks to generate. The PE ratio is calculated either using the current earnings per share (annualised) or the trailing, four-quarter earnings or the expected earnings per share (forward PE).

Many stock market crash courses will teach you to ask yourself whether a company will grow at the rate of its PE. For example, when a stock’s PE is 35 times, the question you are required to pose is whether you expect a 35% growth in the company’s earnings.

But growth is not the only factor to influence PE. The market may be willing to afford a higher price for low debt, high return on equity, or steady payouts. Or, it may be unwilling to pay more if there are risks in the form of cyclicality of business or risk of regulations or competition. Sometimes you will see a high PE stock move to a higher PE without being accompanied by commensurate earnings growth.

Let us take Dabur India as an illustration. The stock returned 24% in the past one year, far higher than the Nifty’s returns. A year ago, the stock’s PE was at 52 times. If you had asked yourself whether the company would deliver an earnings growth of 52% in the next 2-3 years, the answer would have been a clear no. If you, therefore, had left the stock and moved on, you would have missed the opportunity of catching a stock with index-beating returns.

At 62 times PE now, the stock was not de-rated although its earnings did not grow last fiscal. The high PE was awarded for other factors such as its high ROE, low debt, steady, if not high, dividend payouts. Hence, unless you view the PE as a function of multiple factors (for which you need to understand the company), the ratio can be quite misleading.

PEs change with time, rate

Stock markets tend to value stocks for certain qualities and with time, they may value those qualities less and move to better metrics to estimate prospects. Real estate, infrastructure, retailing and media pre-2008 enjoyed high PE valuations but have never gone back to those levels in the past decade. Real estate play, DLF for instance, enjoyed over 50 PE post its listing, going up to even 100 times. It is now at a more modest 27 times median PE in the last three years. Once the markets got a grip that earnings growth in real estate was not a mere function of the land book, the PEs automatically readjusted to lower levels. A similar story played out with IT companies post Y2K and is likely playing out with finance companies now.

Interest rate scenarios, too, influence PE. 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 an higher-valued asset. Hence, in a low interest scenario, you will find fewer stocks with low PE (as is the case now) and that may lead you to believe that there is no opportunity.

PEs also act very differently for some sectors. When your screener throws a commodity company with very low PE, it means its earnings has peaked.

It is likely entering a downturn and may not deliver returns any time soon. Hence, if you didn’t know the sector cycles, you can be taking wrong decisions.

Different interpretations

Another problem is that you can interpret PEs very differently based on how you calculate the PE. For example, in a period of growing earnings in India, analysts tend to use the forward PE (which will naturally be lower as your earnings grow) to hide the fact that current PE is very high. But an analyst who wants to issue a ‘sell’ on such a stock may cite the current PE ratio to make a case for an over-valued stock. As an investor you’ll be left confused, unless you have an idea about the company, its financials, cash flows and very importantly, its prospects.

So, screener lovers… make sure you understand businesses, understand cash flows, and understand risks. Ratios will start making more sense.

(The author is co-founder, Primeinvestor.in)

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