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How to Use P/E for Successful Investing

The Humble Arithmetic behind P/E

My introduction to the P/E ratio happened in business school.

After a primer on P/E from the finance books we were reading, our assignment was to put this knowledge to practical use and select some of the most attractive stocks.

But there was a little twist.

This was a backtesting exercise. We were to look at the P/E ratio three years ago, select stocks that looked most and least attractive then, and see how the stocks had performed.

I must say it was a mixed result. There were winners and losers in both categories, not leading to any conclusion or validating the use of P/E as a valuation tool.

It was then that we learnt that sometimes, a stock with P/E of 25 times could be a bargain, and a stock with a P/E of 7 times a valuation trap.

I'll share more about this, but first, the basics...

P/E Ratio Formula is:

Stock Price per share
----------------------------------------------------
Earnings Per Share (for the last 12 months)

It is the amount of money markets are willing to pay to buy a listed business, for a given net profit in the last 12 months or a year.

For instance, if the business generates Rs 20 of profits in a year, and the stock is priced at Rs 100, the P/E is 5 (Rs 100/Rs 20).

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What this means is if the company keeps earning Rs 20 per share every year, it will take 5 years for all these earnings to add up to the original Rs 100 stock price.

Assuming the earnings remain same every year, you could call it the payback period for the investment you are making in the stock.

The metric is used by millions to decide if a stock is undervalued or valued, thus becoming a key criterion to making investment decisions.

It's perhaps one of the simplest formulas in the world of finance. No wonder the P/E is the most popular valuation tool in the finance and investment industry.

Keeping other factors constant, a stock with higher P/E is considered expensive (likely to lead to lower returns) as compared to a stock with low P/E.

To know more about the P/E valuation method, watch the video below:

The Nuances of Using of P/E as a Valuation Tool

Here's Warren Buffett on the matter:

    Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years.

P/E is only a relative, and not an absolute valuation tool.

What do I mean by that?

Knowing the P/E is not enough to decide whether a stock is over, under, or fairly valued.

You need a benchmark for comparison.

This benchmark could be the industry P/E (the P/E of the industry in which the company operates), historical average of the P/E of the same company or its peers or even the P/E of the broader market.

When it comes to buying a stock, comparing P/E of stocks from FMCG and capital goods industry is like comparing apple to oranges.

Further, PE ratios have two aspects - trailing P/E and forward P/E.

The trailing PE uses last 12 months of earnings. While the forward PE uses the expected earnings a 12 month period in future.

Since the profit from an investment is made to be reaped in future, the forward PE is a better indicator.

But this is provided there is reasonable conviction regarding the future earnings

And the conviction turns out to be correct.

Let's say you have two companies from the software industry - A and B.

A has a P/E ratio of 12 times, while B has a P/E of 15.

It means that for every Rs 1 of earnings, you have to pay Rs 12 to buy A and Rs 15 to buy B.

It would seem A is cheaper than B.

But such a conclusion could be erroneous and incomplete. It ignores the future growth potential.

For instance, let's work with the hypothesis that other qualitative and (historical) quantitative parameters are similar.

Now let's bring in the growth element.

Company A has the potential to grow its earnings at the rate of 10% per annum.

Company B is likely to grow at 20%.

  Company A Company B
Earnings per Share (Rs) 1 1
Current P/E (X) 12 15
Expected growth rates (for next 5 years, per annum) 10% 20%
EPS after 5 years (Y) 1.6 2.5
Forward P/E (X dividend by Y) 7.5 6

For someone looking to invest from a 3 to 5-year perspective, company B, despite trading at a higher P/E multiple, is likely to turn out to be a better investment, and cheaper too.

To make sense of P/E as valuation metric, one needs to use it with other qualitative and quantitative parameters.

These include capital structure (ratios like debt to equity), risks associated to the industry/company, capital allocation (whether the company pays dividends or reinvests its earnings back in the business), returns on capital invested, quality of the management, business's growth prospects, and so on.

It makes sense to pay higher P/E for a business with faster growth, lower debt, lower requirement of capex to grow and high returns on invested capital.

Let's take this analysis a notch higher.

We bring in the concept of reinvestment returns, i.e. how much return a business can generate on a certain capital employed back in the business.

Consider two businesses, A and B.

At the end of FY20, both have earnings of Rs 1,000. The P/E multiple for stock A is 20 times , while for stock B, it is 10 times.

Stock A pays no dividend and reinvests all the earnings back in the business.

Stock B, on the other hand, offers a dividend payout of 70%, i.e. 70% of its earnings are paid out as dividends. 30% is reinvested back in the business.

Stock A is able to earn a return of 25% on the earnings reinvested, while stock B earns a return of 10%.

Which stock would you consider buying, from a 5 year perspective? Stock A has a P/E of 20 times. Stock B has a P/E of 10 times.

Which Stock is Better from a 5 Year Perspective?

  Stock A Stock B
Earnings (Rs million) 1,000 1,000
P/E Multiple 20 10
Current Marketcap (Rs million) 20,000 10,000
     
Dividend Payout 0 70%
Reinvestment Rate (1-Dividend Payout) 100% 30%
     
Returns on reinvested earnings 25% 10%

Assuming that after 5 years the P/E multiple of both stocks would be at 15 times, here's what your returns would look like:

  Stock A Stock B
Earnings (Rs million) 1,000 1,000
P/E Multiple 20 10
Current Marketcap (Rs million) 20,000 10,000
     
Dividend Payout 0 70%
Reinvestment Rate (1-Dividend Payout) 100% 30%
     
Returns on reinvested earnings 25% 10%
Dividends over next 5 years - 3,716
5th Year Earnings 3,052 1,159
5th Year P/E Multiple 15 15
Marketcap after 5 Years 45,776 17,388
     
Internal Rate of Return (IRR%, including dividend) 18.00% 12.20%

Stock A, which one entered at a P/E of 20 times, and that offered no dividends, would have risen at a CAGR of 18%.

Stock B, with entry P/E of 10 times, and with dividend payout ratio at 70%, would have risen at a 12.2% CAGR.

So if you are reasonably confident of spotting companies that can grow and reinvest their incremental capital at high rates of return, entering at seemingly higher P/E makes sense.

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How to Pick Stocks using P/E Ratio

You could find the current or latest P/E ratios on a lot of financial websites for free.

But it's not prudent to assess valuation or base stock selection on that criteria.

For instance, if the economy goes under a lockdown, there is high chance that last 12 months earnings will look abnormally low.

Due to lower base of earnings, the P/E is likely to look inflated. It may not necessarily mean that the stock is expensive.

Similarly, in case of cyclical businesses, in a year with very high profits, the earnings in the denominator would be high, and hence the P/E ratio may look lower. Again, you should not jump to the conclusion that the stock is cheap.

For stable companies/mature businesses, where the future is likely to be more or less in line with the past, one of the ways to address this issue is to consider long-term average of P/E ratio, and to focus on normalised earnings.

For businesses that are in a declining or high growth phase, using historical P/Es will not help.

In such cases, one must consider if the future prospects are likely to be better or worse for the stock in question and assess valuations accordingly.

Valuation Illusions - When P/E hides more than it reveals

Numbers just tell you half the story. Sometimes, the wrong story.

Creative accounting is prevalent in corporates, and earnings or profits could be manipulated.

In fact, profit and loss statement is the easiest place for managements with bad ethics to cook their books.

The misdemeanors include counting receivables as sales that are never likely to bring in cash, frequent restructuring exercises, suspect related party transactions, capitalising expenditures that should ideally be expensed, changing depreciation and other accounting policies regularly to make the earnings look better.

If you use P/E as a sole criterion, there is a good chance that you are working with a distorted base.

It's not just earnings manipulation. Sometimes profits could be inflated due to a one-time sale of an asset which does not serve as a meaningful base to assess the earnings or return potential in the long-term.

Earnings should be seen in conjunction with cash flow from operations (in case of growing businesses), or free cash flows (in case of stable/mature businesses).

A wide divergence or opposite trends in the profits and cash flows, is a good reason to be cautious and not take reported earnings on the face value.

Market Valuation - Sensex and Nifty P/E

While a stock's P/E reflects how a stock is value in relation to its earnings, Sensex P/E compares the benchmark index price in relation to combined earnings of the 30 companies (constituents) in the Sensex.

Similarly, Nifty P/E compares Nifty value in relation to combined earnings of 50 companies in the Nifty.

Comparing long-term P/E of a benchmark index with its current P/E gives an indication of whether the market is over, under or fairly valued.

It is considered overvalued (expensive) when the current P/E is much higher than the long- term average, and vice versa.

The long-term average for Sensex P/E is 19.6 times.

You could access the latest Sensex P/E here.

The long-term average for Nifty 50 P/E stands at 20.2 times.

The latest Nifty P/E is available here.

This chart gives a sense of current versus historical Sensex valuation.

current versus historical Sensex valuation

List of Low P/E Stocks

One of the most common ways retail investors use P/E in their selection is to check for a list of low P/E stocks, such as the one below.

Stock P/E (x)
HDIL 1
HOTEL LEELAVENT. 1.3
GFL 1.6
EROS INTERNATIONAL 1.8
OMAX AUTOS. 2.1
J KUMAR INFRA 2.1
SPML INFRA 2.1
PATEL ENGG. 2.9
PRAKASH INDUSTRIES 3.3
PARAMOUNT COMM. 3.3
WEST COAST PAPER MILLS 4.3
Source: Equitymaster Screener (run on Dec 07, 2020)

While this could be a starting point, the real work begins next, i.e. evaluating such a selection from a fundamental perspective.

With the knowledge and caveats above, I think you are now ready to use a more wholesome approach to pick stocks. An approach that adds more parameters like profits growth, debt to equity ratio, returns on capital employed, etc to further fine tune this list.

Here's the list of stocks that incorporate above mentioned parameters and look interesting on the Equitymaster's Stock Screener.

SCRIP* P/E(x) PROFIT GROWTH(%)
(5-Yr Avg)
OPERATING PROFIT MARGIN(%)
(5-Yr Avg)
DEBT/EQUITY RATIO(x)
(5-Yr Avg)
ALEMBIC PHARMA 18.1 19.9 22.8 0.1
ITC # 18 10 37.5 0
AMBUJA CEMENT 17.6 13.4 16.2 0
BHARAT ELECTRONICS # 17.1 14.7 20 0
NESCO 16.4 17.4 68.8 0
CONTROL PRINT # 15.7 16.5 25.7 0
GLENMARK PHARMA # 15.4 11.1 18 0.8
KRBL 11.9 14.5 18.7 0.1

The Stock Screener runs on Equitymaster's own database, which comprises India's leading 490 companies.

*Data is consolidated wherever applicable

Please note that these are not recommendations by any stretch of imagination.

This is just a small list of stocks that score well on our screener and worth digging further into.

Conclusion

P/E Ratio is the most frequently and also most misused valuation tool for investing.

While a low P/E stock may seem intuitively cheap, it could be reflection of risk in the business model and declining earnings in the future.

P/E can be a powerful valuation tool, only when used in conjunction with fundamentals. To learn more about fundamentals of investing, click here.

Recommended Readings on P/E Ratio

FAQs

1) What is P/E ratio and what is its importance in buying a share

The formula for P/E ratio is:

Stock Price per share / Earnings Per Share (for trailing 12 months)

P/E ratio suggests how much money you are willing to invest in a stock for every unit worth of profit after tax in the stock (earning per share). P/E is a relative valuation tool, and suggests whether the stock could be over, under, or fairly valued as compared to its peers in the same industry, broader markets and even as compared to its own historical average.

2) Are stocks with low P/E ratio always better?

Stocks with very high P/E are likely to be expensive. However, the opposite is not always true.

P/E ratios vary across industries. The ones in a mature phase and with low growth potential, such as utilities, are likely to have lower P/E ratios as compared to growth companies.

So, when you compare P/E ratios of two stocks, the benchmark should be its peers in the same industry and the long term P/E of the same stock. You also need to factor in future growth prospects and risk quotient in the business.

Selecting stocks solely on the basis of low P/E is likely to lead to poorer diversification in the portfolio, and potentially high risks.

3) What is considered an ideal P/E ratio to buy stocks in India?

P/E is a very dynamic metric. It varies across industries and cycles. When it comes to investing in a single stock, one has to be mindful of how the stock's P/E compares to peers, quality of management, growth prospects, and risk quotient in the business.

However, at the index level, the long-term P/E average is 19 to 20 times.

If the Sensex or Nifty P/E exceeds this value by a wide margin, there is a possibility of markets being in an overvalued or heated zone.

On the other hand, if the index P/E is well below or around its long-term average, it could be a good time to increase allocation to stocks or equities in one's portfolio.

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