Why You Must Ignore these 5 Stocks Trading Below their 5-Year Average PE Ratio

The BSE Sensex index has been at its volatile best in the past year. It has been swinging like a pendulum every few months, primarily led by weak global cues.

From US jobless data releases to concerns over the banking crisis, the past year has been very turbulent for the markets.

However, these turbulent pockets results in low-valued stocks. This presents long-term investors with a wonderful opportunity to generate outsized returns.

But investors must be cautious during such times, especially while valuing stocks.

A common mistake investors make is relying solely on the PE ratio to value every stock. They use a single valuation tool across industries with vastly different business models, growth prospects, and risk profiles.

A P/E ratio is a valuation metric that compares a company's current stock price to its earnings per share (EPS). A lower P/E ratio indicates that a stock is cheaper relative to its earnings.

But just because a stock is trading below its 5-year average P/E ratio, it doesn't necessarily mean it's a good buy.

In fact, there may be several reasons why a stock's P/E ratio is lower than its historical average. These can be a temporary dip in earnings or a change in the company's growth prospects, etc.

So keeping this in mind, we explore the top 5 stocks trading below their 5-year average P/E ratio and explain why investors should ignore them.

#1 Coal India

First on our list is Coal India.

Coal India, owned (80%) by the Government of India, is the largest coal producer globally.

The company is a significant supplier of coal to power plants and other industries that use coal. It contributes to almost 80% of India's total coal output.

The stock is trading at P/E ratio of 4.7, the lowest in 5 years. The current valuation is lower than its average P/E of 10.3, a discount of 45%.

A cash-rich, monopoly business with minimal debt on the books is available at its 5-year low PE. What more could you ask for, right?

Not necessarily.

You see, Coal India is a commodity business, which is cyclical in nature. This means the stock prices of such companies typically rise and fall in sync with commodity prices. So, in this case, the stock value will rise along with the price of coal and vice versa.

The earnings of cyclical businesses tend to fluctuate during the peak and trough of their cycles. Therefore, relying on earnings alone to value commodity stocks can be misleading, rendering the PE multiples meaningless.

However, there are other relatively stable valuation metrics that can be considered.

These are the price-to-book value (P/BV) or the Enterprise Value (EV) /Earnings before interest depreciation tax and amortisation (EBITDA) ratio.

When it comes to cyclical companies, the EV/EBITDA ratio is a more comprehensive measure of a company's financial health as it accounts for a company's debt and other liabilities.

The EBITDA allows investors to compare companies with different levels of debt and depreciation. As cyclical companies may have high levels of debt and depreciating assets, using EBITDA can help better gauge the company's earnings potential.

As can be seen here, Coal India's EV/EBITDA ratio presents a different perspective in comparison with the PE ratio.

The company's current EV/EBIDTA multiple stands at 2.4, which is not the lowest in the past 5 years. Moreover, it is trading at 20% discount to its 5-year average EV/EBIDTA of 3 times.

These numbers suggest that the stock is not substantially undervalued. Considering the company's strong performance over the past five years, this is not surprising.

Coal India Financial Snapshot (2018-2022)

	2017-2018	2018-2019	2019-2020	2020-2021	2021-2022
Revenue Growth (%)	-27.37%	16.29%	-2.94%	-8.28%	20.84%
Operating Profit Margin (%)	10.89%	20.89%	19.73%	16.63%	17.62%
Net Profit Margin (%)	5.38%	11.83%	11.75%	9.44%	10.71%
Return on Equity(%)	31.49%	74.90%	56.99%	36.99%	43.63%

Source: Equitymaster

While the sales have grown at a 5-year CAGR of 5.3%, the net profit is up 2.5 times. The company has negligible debt on its books, and the business is a cash cow. This has allowed them to reward shareholders generously, as visible in the 5-year dividend yield of 7.6%.

The returns are robust, as depicted in the 5-year average return of equity (RoE) of 45.6%.

To know more about the company, check out its financial factsheet and latest financial results.

#2 ONGC

Next on our list is Oil and Natural Gas Corporation (ONGC).

ONGC is India's largest crude oil and natural gas producer, accounting for roughly 70% of the country's domestic production.

Its wholly-owned subsidiary, ONGC Videsh, is the largest Indian multinational in the energy space, participating in 36 oil and gas properties across 17 countries.

According to the PE ratio, the stock is highly undervalued. It is trading at 5 times, much below (33% discount) its 5-year average value of 7.5 times. But given the cyclical nature of the business, the PE ratio fails to present an accurate portrayal.

The EV/EBITDA ratio, on the other hand, indicates otherwise. As per this ratio the stock is trading at a multiple of 3.5 times, a discount of just 8% to its 5-year average of 3.8 times. Now this tells us that the stock is not highly undervalued.

The relatively strong performance of the business, led by a rally in the crude oil prices has resulted in the current valuation.

ONGC Financial Snapshot (2018-2022)

	2017-2018	2018-2019	2019-2020	2020-2021	2021-2022
Revenue Growth (%)	12.94%	27.47%	-6.11%	-22.43%	57.08%
Operating Profit Margin (%)	18.57%	18.22%	14.45%	16.52%	16.58%
Net Profit Margin (%)	7.15%	6.69%	2.46%	5.61%	8.95%
Return on Equity(%)	13.09%	14.50%	4.99%	9.55%	19.91%

Source: Equitymaster

The sales and profits growth has been resilient, having doubled in the last 5 years. The RoE has also improved and was 18.4% in the financial year 2022.

ONGC has a debt-to-equity ratio of 0.3 times, which isn't significantly alarming. But despite some debt on its books, the company has remained a dividend paymaster, boasting a 5-year dividend yield of 4.6%.

To know more about the company, check out its financial factsheet and latest financial results.

#3 Hindalco

Third on our list is Hindalco.

Hindalco is one of India's top aluminium producers.

It has a total aluminium capacity of 1.3 MTPA (million tonnes per annum).

The company's wholly-owned subsidiary, Novelis, enables the firm to operate in the downstream aluminium industry. Novelis is a global leader in aluminium rolled products with 4 MTPA capacity, catering to both beverage cans and auto sheets sectors.

Although the stock's current PE ratio (7.8 times) indicates the it's available at a discount of 25% to its 5-year average PE ratio of 10.4, it may not be a reliable indicator.

This is because the cyclicality of the business significantly impacts its earnings, rendering the PE ratio meaningless in this context as well.

And so, a safer bet would be to use the EV/EBITDA ratio.

Hindalco is trading at an EV/EBITDA of 5.5 times, a minor 3.5% discount to the 5-year average of 5.7 times.

These numbers suggest the stock isn't highly undervalued. And this is well-supported by the fact that the business has done well in the short and long term.

HIndalco Financial Snapshot (2018-2022)

	2017-2018	2018-2019	2019-2020	2020-2021	2021-2022
Revenue Growth (%)	15.16%	12.96%	-9.41%	11.77%	46.92%
Operating Profit Margin (%)	12.97%	12.75%	13.11%	14.22%	15.11%
Net Profit Margin (%)	5.36%	4.21%	3.19%	3.92%	7.28%
Return on Equity(%)	12.31%	9.77%	6.49%	8.28%	19.59%

Source: Equitymaster

The bull market in metal prices has certainly helped the stock. While the sales are up 13.7% on a 5-year CAGR basis, the profits have more than doubled.

This has helped it expand the return on equity, which was 18% in the financial year 2022. The company has a debt-to-equity ratio of 0.7 times, which is not worrying but is on the higher side.

To know more about the company, check out its financial factsheet and latest financial results.

#4 Tata Steel

Fourth on our list is Tata Steel.

Tata Steel is a leading steel producer globally, with a total crude capacity across three countries. It operates at a capacity of 34 MT - India (24 MT), UK (3 MT), and Netherlands (7 MT).

The company enjoys a significant cost advantage, with full integration in iron ore in India and 20% integration in coking coal.

The current PE ratio of the company is 7.4 times, which is 22% lower than its 5-year average PE ratio of 9.5.

However, due to the cyclicality nature of the business, the PE ratio may not be a dependable indicator in this situation. Therefore, it should be interpreted with caution.

A better valuation tool is the EV/EBITDA ratio. Tata Steel is trading at an EV/ EBITDA of 4.8 times, a discount of 14% to its 5-year average of 5.6 times. This indicates the stock is undervalued...and rightly so.

The stock has corrected over concerns about the losses reported by the company in the quarter ending December 2022. While the Indian business has churned a profit, the European business has been a big drag for the company.

Barring this year however, the business has performed admirably.

Tata Steel Financial Snapshot (2018-2022)

	2017-2018	2018-2019	2019-2020	2020-2021	2021-2022
Revenue Growth (%)	10.07%	28.03%	-5.21%	4.36%	55.52%
Operating Profit Margin (%)	17.98%	19.54%	13.19%	20.07%	26.35%
Net Profit Margin (%)	14.15%	5.83%	0.79%	5.23%	17.11%
Return on Equity(%)	38.95%	14.70%	1.70%	11.33%	44.72%

Source: Equitymaster

The sales and net profit have both doubled in the past 5 years. The RoE has also improved, standing at 44.7% in the financial year 2022.

The company has improved its financial health substantially, repaying a large amount of debt in the last 5 years. The debt-to-equity ratio was at 0.4 times in the financial year 2022.

To know more about the company, check out its financial factsheet and latest financial results.

#5 Grasim

Last on our list is Grasim.

What started off as a textile manufacturer, underwent a significant transformation to emerge as a dominant diversified player with a prominent presence in varied sectors.

Grasim is not only the largest producer of viscose rayon fibre in the world, but it is also a leading Chlor-alkali, linen, and insulator player in India.

Apart from the conglomerate, through its subsidiaries, UltraTech Cement and Aditya Birla Capital, is India's largest cement producer and a leading financial service provider.

In terms of valuations, the PE ratio suggests the company is highly undervalued. Grasim's current PE ratio is at 13.4 times, a discount of 15% to the 5-year average PE ratio of 15.9 times.

However, due to the diversified nature of its businesses, the PE ratio may not be a dependable indicator.

A sum-of-the-parts valuation approach is a better fit to determine the value of the company with multiple businesses.

This approach involves valuing individual businesses separately and then aggregating the values to arrive at a total valuation for the company.

Grasim Financial Snapshot (2018-2022)

	2017-2018	2018-2019	2019-2020	2020-2021	2021-2022
Revenue Growth (%)	53.43%	37.41%	-2.31%	1.61%	24.61%
Operating Profit Margin (%)	21.72%	21.36%	22.17%	23.62%	20.53%
Net Profit Margin (%)	6.08%	3.36%	8.00%	8.10%	10.33%
Return on Equity(%)	8.33%	4.77%	11.52%	11.10%	15.21%

Source: Equitymaster

Grasim's revenue has nearly doubled and the net profits are up 3 times over the last 5 years.

Despite its myriad investments in subsidiaries etc., the company boasts a healthy balance sheet. The RoE has also improved, standing at 15.2% in the financial year 2022.

To know more about the company, check out its financial factsheet and latest financial results.

In conclusion

While the EV/EBITDA ratio is a more comprehensive measure of a company's financial health, no single valuation metric alone can be a fool proof way to identify a good investment.

So do your due diligence before making any investment decisions. Considering other factors, such as industry trends, management quality and the competitive landscape, can go a long way when picking stocks for your portfolio.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...