Wednesday, February 12, 2020

Why depending only on Price-to-Earnings Ratio (P/E ratio) may not be good Idea ?


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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