Why depending only on Price-to-Earnings Ratio (P/E ratio) may
not be good Idea ?
“What is the
P/E ratio?
The price/earnings,
P/E, or ‘multiple’ as it is sometimes called, compares:
- Company’s stock price
with its historic earnings per share (EPS). It is effectively a
shorthand for how expensive or cheap a share is compared with its profits.
- At times you will see the
stock price divided by the forecast EPS as a way of producing a
‘predicted’ P/E ratio using analysts’ expectations.
- Other times the EPS
figure will be produced from the past two quarters and the forecast
two quarters in order to smooth out the lag between annual results – this
is known as the ‘rolling’ P/E.
Calculating the
P/E Ratio: A Quick Review
On the surface,
calculating price to earnings is fairly straightforward. The first step in
generating a P/E ratio is to calculate earnings per share (EPS). Typically,
EPS equals the company's after-tax profits divided by the number of shares in
issue.
EPS=Post-Tax /
Number of Shares
From the EPS, we can
calculate the P/E ratio. The P/E ratio equals the company's current market
share price divided by the earnings per share for the previous year.
P/E = Share Price
/ EPS
The P/E ratio is
supposed to tell investors how many years' worth of current earnings a
company will need to produce in order to arrive at its current market share
value.
Analysis
For years, most of the analysts and investors alike use Price-to-Earnings
Ratio (P/E ratio) to assess the value of a company’s stock. A low P/E ratio is
usually assumed to mean that the stock is undervalued and should be purchased,
while a high P/E implies an overvalued stock that should be sold. A deeper analysis
indicates that it is actually the percentage increase in EPS that should be the
determinant of buy/sell decisions. Here is why:
You are missing on good stocks If you
avoid purchasing high P/E stocks (which are at 40-60 times earnings, or even
greater), you may be missing out on attractive investments that have the
potential to become multi-baggers going forward. i.e. companies like HDFC Asset
Management, Titan, Hindustan Unilever, Avenue Supermarts, etc. would not
feature in your prospective stock picks. These stocks, which were quoting at
‘high’ P/E multiples, have risen to new highs as a result of strong growth in
earnings. Their earnings growth has been recognized by large institutional
buyers, which has caused their stock prices to move to higher levels, and
therefore, ‘higher’ P/E multiples. As a result, you would have missed out on
attractive investment opportunities that would have boosted your portfolio
value significantly.
On the other hand, purchasing a stock just because its P/E ratio makes it
appear to be a bargain may not be good decision. In fact, there could be
good reasons for a stock quoting at a low P/E multiple and there are strong
chances of the stock moving further down to eventually become a penny stock.
What about analysing company’s P/E with its Industry Again, it is a wrong way to use of P/E ratio and compare it with its
industry P/E and conclude that the one is selling at the cheapest P/E is always
undervalued and therefore the most attractive purchase. The reality is, if a
stock is trading at the lowest P/E it is possibly due to its poor earnings
record.
Artificially inflated "E" firms
that have recently sold off a business can have an artificially inflated
"E" and a lower P/E as a result. A company may book a big one-time
gain from the sale of a division, boosting reported earnings, but based on
operating earnings, the stock may not be cheap at all.
False reporting or misrepresentation of balance sheet reported earnings can sometimes be inflated (or depressed) by one-time
accounting gains (or charges). As a result, the P/E ratio can be misleadingly
high or low. For example, a firm's earnings can be depressed due to a one-time
charge for litigation or other extraordinary events. This may in turn give the
stock what appears to be a sky-high trailing P/E.
Companies with Cyclical business: They go
through boom and bust cycles- winter wear manufacturer, A/C manufacturers and
auto manufacturers are good examples- require a bit more investigation.
Although you would typically think of a firm with a very low trailing P/E as
cheap, this is precisely the wrong time to buy a cyclical firm because it means
earnings have been very high in the recent past, which in turn means they are
likely to fall off soon. Likewise, a cyclical stock is going to look the most
expensive when its "E" has bottomed and is about to start growing again.
To build a robust portfolio, invest in companies with the best quarterly
and annual earnings growth, the highest return on equity, the widest profit
margins, the strongest sales growth, and the right buy price. Do not fall
into the P/E trap.
Sources:
Various publications
Disclaimer: The
information provided herein is based on publicly available information and
other sources believed to be reliable, but involve uncertainties that could
cause actual events to differ materially from those expressed or implied in
such statements. The document is given for general and information purpose and
is neither an investment advice nor an offer to sell nor a solicitation. While
due care has been exercised while preparing this document, we do not warrant
the completeness or accuracy of the information. We will not accept any
liability arising from the use of this material. The recipient of this material
should rely on their investigations and take their own professional advice.
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