PE- Price to Earnings (ratio) is one of the most common and probably the oldest known ratios used for valuing stocks and companies and even businesses. Interestingly, its also the most misunderstood ratio- purely because of the multiple implications that correspond with the market scenarios and conditions during the said period of time.
What is a Price to Earnings Multiple ?
By definition it is the fraction of “What you pay” divided by “Periodic Earnings” of what you pay for. The numerator is an absolute amount while the denominator is (probably) recurring, hence PE can also be interpreted as the number of periods required for the investment to earn for you what you pay for it. For instance if you buy a stock at 10x PE, where E=annual EPS- it would take the investment 10 years to earn you, your investment.
However, the same ratio is as volatile as the stock price itself- increasing or decreasing as the stock price goes up or the earning go down.
Also, The reciprocal of PE = EY- Earnings Yield, viz. - the fraction of “What an investment earns for you” divided by the “Investment / What you pay”. For instance- say you investment a $100 in a bond paying $5 each year- the yield is 5%, similarly if you buy a stock of the same price with an annual EPS of the same $5 is said to have an EY of 5% or a PE of 20x
Understanding it’s Implications
The ratio becomes a common reference for comparing stocks with other stocks and more often with the market- however, it makes very little sense and usually contributes to erroneous judgement.
- PE has more to do with prevalent interest rates than it does with the stock markets. Historically, 1/PE or Earnings Yield have remained stable around 1/2 to 1/2.5 of the respective 10yr Treasury Bond rates. Example- For India, while 10 year TBOND rates are ~6%, the EY should be around 1/2 or 3% which translates to a trailing PE of 33x.
- Common comparable metric for companies within the same industry- since PE takes Net PAT into the equation which is impacted by depreciation, interest costs etc. While, it would be fair to assume companies within the same sector would have similar earnings profile the same can not be assumed for companies from other sectors.
- Comparable metric for a company with its previous valuations. If a company has in the past always traded above 50x (ex- NESTLEIND) at 30x it would be considered cheap or probably PE alone would be inconclusive.
- Compare “well- diversified” portfolios with other such portfolios.
- To conclude a company is trading cheap- While, I am always against a company being valued purely on the basis of PE there are a few exceptions. One major exception is- A debt free company, with stable earnings (consistent year on year growth in net earnings) trading at less than 10x price to past 3 year average eps with P/BV of less than 1.3x can definitely be termed cheap.(screener linked for ready reference).
We had many such opportunities over the year of 2020.
PE makes for the wisest background checks before any investment decision is made. Most importantly before buying a stock or investing in a portfolio that has already given great returns in the past. PE, tells investors what is the price to be paid per share for one rupee of earning generated by the company/ Portfolio.
A company was trading at 100/sh at 10x PE would mean it had an EPS of Rs.10. Let’s assume if the EPS increased to Rs.20 at 10xPE the stock should trade at 200/sh, however 400/sh would imply 40xPE and so on. At which point careful judgement is required to understand if the EPS growth can match up to that in the price/sh.
How would this work for a portfolio ?
The PE/PB or any ratio for a portfolio is calculated as a weighted average of such ratio of all the stocks in the portfolio, with weights being capital allocations to the stocks.
Similarly with MFs, which are marketed purely on the basis of past returns. Point here being, if a portfolio has performed over the recent past. Probably its PE is now much higher than before because of the tendency of a price to overreact to information.
When was the last time you checked the PE or PB of your portfolio or mutual fund investments?