P/E Ratio Unplugged

 | July 18,2011 10:51 am IST

If you are thinking about stocks you are thinking about P/E ratio. This is one of the most commonly used valuation multiples in the stock market community.

Although very simple to calculate, it is one with gargantuan implications.

 

The P/E ratio is the market’s assessment of a company’s future prospects. It is calculated by dividing the market price of the stock by the EPS (this figure for EPS excludes extra ordinary items).

 

The market judges a company on various parameters and assigns a multiple to the future growth. Why is that Infosys commands such a high multiple say as compared to Polaris? There are a number of factors on which the market distinguishes between Infosys and Polaris and then assigns the multiple. What are these factors and how do they affect the valuation of a company?

 

There are broadly seven determinants of a stock’s P/E ratio. These are…

1)Growth- this is one of the most important factors that affects the valuation of a company. The market is always appreciative of a company that is able to define and achieve its growth path. Hence every company makes an endeavour to increase its after tax earnings. This is also one of the causes that prompted many Wall Street companies to fudge their financials to show an increase in the EPS. The market is always wary of companies that are unable to increase after tax earnings. Thus we find that HLL, one of the most prominent Indian companies quoting at a low P/E. This is because the company has been able to maintain its profitability only through cost cutting and better supply chain management and there has not been much growth in the top line. This company had at one time been the darling of the bourses but now is languishing at very low prices.

 

2)Dividends: A bird in hand is worth two in the bush. This seems to be the idiom guiding the Indian investors. A company paying good dividends is generally favoured by the markets than a company that retains its earnings. Investors want ready cash and generally discount companies that donot share their earnings. This is one of the primary reason why MNC stocks command higher P/E than their Indian counterparts.

 

3)Stability of Earnings: This is another important determinant of the P/E ratio of a stock.. Stocks, which grow in a stable predictable way, find favour with the investors and generally command a high P/E. One recent example of this is software companies, which at one time were commanding very high P/E but are now languishing primarily because of highly volatile earnings.

 

4)ROIC: The basic idea of this concept is to determine the returns generated by the operating assets of a company. The ROA tries to gauge the returns generated by all the assets of a company. This includes assets, which are not used in the operations of a company. However the ROIC aims at judging the performance of a company in terms of returns generated only by the operating assets. Thus assets such as marketable securities are excluded in the calculation of the operating assets. A company with a high ROIC is looked favourably by the markets. Ranbaxy had been accorded a low P/E as compared to DrReddy labs primary because of low ROIC.

 

5)Debt in the capital structure: One of the most significant items in the check list of Warren Buffett , the world’s most famous investor ,while making an investment decision is leverage. Presence of reasonable amount of debt in the capital structure helps to gain the advantages of Trading on Equity. However unreasonable amounts of debt can lead to fiscal distress. Thus companies with high debt in their capital structure are looked down by the markets and generally trade at low P/E’s.

 

6)General Market Trends: This is another significant factor that affects the P/E of a stock. In the short run the markets are generally irrational in valuing a company. There are certain sectors that find favour with the markets. For example in the software boom tech stocks commanded exceedingly high P/E’s. The pharma stocks were in vogue some time back and then it was Bio tech… some sector is in general fancied by the market.

 

7)Interest Rates: The level of interest rates in an economy has a big effect on the price earning multiple of stocks. With a fall in the level of interest rates the fixed income market becomes unattractive because of low interest and hence money is diverted to the stock markets. Also because the fall in the interest rates lowers the interest burden of the companies there is a surge in their profits.


Though a very useful valuation multiple the P/E ratio must be used with caution. The higher the P/E the more you are paying for the estimated stream of future earnings. However it must be remembered that with high P/E the downsides are also high. If estimated earnings are not realised or if the stock falls out of favour with the stock market then such an investment may turn out to be an expensive proposition. Suppose, a company goes from a P/E of 50 to 25 but still maintains an earnings of 1$ a share then the value will fall from 50$ to 25$ even though the company is in profits. It is essential to keep in mind that the P/E is the net result of a number of factors and this valuation multiple should be judiciously used along with other valuation methods.


Concluded.

 

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