UDERSTANDING PE RATIO

How to define PE Ratio ?

PE Ratio or Price to Earnings Ratio is nothing but the current stock price divided by the earnings per share (EPS). Earnings per Share can be for trailing 12 months or for  a particular financial year.

How to calculate PE Ratio ?

Let us assume a current price of financial voyager shares is $100 per share and EPS is $10 for trailing 12 months. Then , the PE Ratio of Finance Voyager becomes 100/10 = 10.

(Earnings per Share is calculated by dividing the net profit of a company by the total number of shares).

What does the PE Ratio tell us ?

Let us take the earlier example of Finance Voyager ,

Stock price – $100

EPS – $10

PE Ratio – 10

We can easily see it will take 10 years for Finance Voyager to accumulate profits which are equivalent to the present share price. So in this case , assuming no increase or decrease in earnings , and at the rate of $10 per year , it will take 10 years for Finance Voyager to accumulate $100. 

We can easily see how important PE Ratio is as it indicates us about relation between current share price and current earnings.

At what PE Ratio should I buy a stock ?

Market decides PE Ratio of a company on following parameters –
  1. Anticipated growth in earnings
  2. Track record of management
  3. Amount of debt on the books
  4. Sector to which the company belongs(companies in sunrise sectors command higher PE)
  5. Headwinds or tailwinds the sector or company is facing
  6. Competitive advantage this company holds over its competitors
  7. Sector leadership ( sector leaders get a high PE)
  8. Company is gaining market share or losing market share
  9. Business model of the company (whether the company requires heavy capital investments to grow or it can grow on accrued earnings without any investments )
  10. Company products ( companies with strong brands or loyal customer base or unique product command higher PE)
  11. Company’s debtor days(companies with low debtor days command high PE as they pricing power over their consumers)
  12. Free cash flow ( companies which generate free cash flow command higher PE )
  13. Companies which utilize their capital efficiently and generate high return on capital command higher PE
  14. Companies with higher profit margin command a higher PE
  15. Market sentiment ( sometimes euphoric market sentiments about a particular company or sector generates higher demand for shares than the available supply and this results in higher PE

How much PE Ratio one should pay for a company ?

This is a very basic question every investor should ask himself and honestly try to find the answer. As we have already seen PE Ratio depends upon a combination of very complex and dynamic factors . It is very difficult to exactly quantify the desirable PE Ratio at which one should buy or sell a stock.

But we can use certain techniques to arrive at an informed decision.

  1. Calculate the historical PE of the same company over a period of time and compare it to the present PE . This will at least tell us whether the present PE is in the upper band or in the lower band or in the mean band for the same company. One should at least make sure that the present PE is in the lower band or nearer to the lower band. In the absence of compelling reasons , one should avoid buying a stock at higher PE band of the same company.
  2. Calculate the average sectorial PE of the sector to which the company belongs. Comparison of company PE to the average PE of the companies in the same sector will tell us the company is trading at premium or discount to the average sectorial PE. In the absence of compelling reasons , one should avoid buying a company which is trading premium to the average sectorial PE.
  3. Identify at least two similar companies which are direct competitors to our company and compare our company’s PE Ratio to theirs.
  4. Check at least last three years growth and estimate at least next three years growth . Based on this , calculate the EPS after three years and forecast the PE after three years. This technique is basically used to value the growth stocks as they appear very expensive based on current earnings. This is a very complex technique and it requires considerable sectorial knowledge . For beginners , they should try to avoid this technique. One should always remember , there are plenty companies in the market which are suitable for your analytical skills and we should stick with what we know and what we understand. But as a market participant , as we mature ,  we should try and learn this technique. 
  5. PE Ratio of a company is sometimes related to the overall market or Index PE. We can check historic relation between company PE Ratio and overall Index/ Market PE Ratio. This comparison will help us to understand whether the company is trading at premium or discount compared to the overall Market PE Ratio. Sectorial rotation of money keeps on happening in the market . This particular technique will help us to understand whether this particular sector is in hot demand or out of favour.

Risks associated with buying high PE stocks –

Sometimes ,because of anticipated growth , high quality management , competitive advantages, wrong estimation and forecasting we end up buying high PE stocks.

  1. If the growth tapers out , not only the forecasted PE will reduce but the market will shrink PE Ratio . These two factors combined can make the stock price go down significantly .
  2. Unexpected events (black swan) can cause significant stock downturn.
  3. Disruptive technology and competition can render our company products redundant. This is a significant risk especially with technology companies.
  4. Geopolitical events like earthquakes, government change, war, floods , droughts , protests can cause significant downturn in the stock price.
  5. Detection of fraud in the company’s book can cause significant stock price downturn.

We can see there are various risks involved in buying high PE stocks . Therefore, it is very important to carefully analyse and understand the PE Ratio of a company.

Risks associated with buying low PE stocks –

It is not always safe to buy low PE stocks . Stocks which are trading at low PE are trading at that valuation for a particular reason. In general , market is an efficient price discovery machine . If various market participants are paying very low PE for that particular stock means there has to be some reason for that.

When we buy low PE stocks , we must understand the reasons why that particular is cheap or the market is assigning very low PE to that particular company.

Once we understand these reasons , we must try to forecast in future whether any of these reasons ( because of which the market is giving less PE)are going to change. If our analysis suggests that these reasons and current circumstances are definitely going to change in future for better then only it makes sense to buy low PE stocks.

When stocks become multibaggers ?

When we buy low PE stocks and the stock’s earnings grow consistently , this results in a twin effect of PE expansion as well as earnings growth and the stock becomes a multibagger. This a very rare phenomenon and in an investing life of a common investor , at the very best , hardly couple of times we encounter this phenomenon.

When does a stock become a compounder ?

After thorough analysis , when we buy a stock closer to the lower end of its historical PE band or at the average PE band and the company earnings grow consistently we get a steady compounder over a longer period.

This is the sector which we will be targeting the most as there is a reasonable chance of catching a steady compounder if  we equip ourselves with required analytical skills.