Understanding The ‘Price-To-Earning Parameter
Equity valuations, it is said, is the key to understanding the equity markets. Valuation is also one of the most confusing aspects of the equity market game. Shreya Chaware focuses on a group of stocks where the PE expansion was most visible. She also discusses at length why certain stocks always manage to fetch a premium over the other players in the same industry
The price-to-earnings (PE) ratio is the most widely used valuation metric across the investing world. The ratio is widely used for no reason. It is easy to calculate and at the same time the data is readily available. Also, the ratio is easy to interpret and reveals tons of valuable information for discerning investors. While the importance and popularity of PE ratio is welldocumented, several investors do get carried away with the simplicity of the PE ratio and take investment decisions based on certain myths prevailing in the market. For example, ‘low PE’ stocks are best as they are value stocks while ‘high PE’ stocks are bad for investments as they are overvalued stocks.
It is observed that several investors bank on the so-called low PE stocks and fall for ‘value traps’ as majority of the low PE stocks continue to underperform year after year. In reality, it is also observed that certain stocks continue to outperform year after year even when trading at high PE ratio. For example, there are stocks like Bharat Electronics and CEAT which are constituents of the BSE 500 index and have underperformed the Sensex in the past five years even while reflecting low PE ratio in 2016.
At the same time, we can see stocks such as Nestle, HUL, Dabur, Asian Paints, Berger Paints, 3 M India, Aegis Logistics, AstraZeneca Pharmaceuticals, Astral Limited, Bajaj FinServ, Britannia Industries, etc. always trading at high PE ratio when compared to the market indices and also when compared to the industry average, and yet outperforming the markets consistently over a long time horizon. Why do certain stocks outperform in spite of trading at astronomical PE multiples and why do certain stocks underperform in spite of trading at below the industry average PE multiple?
Earnings and PE Ratio
PE ratio is nothing but the net profit after taxes divided by the number of outstanding shares. Intuitively, PE ratio also tells us how many years we will need to remain invested to get back our invested amount. This is also one of the reasons why high PE stocks are not looked at as value buys. Current earnings and expected earnings’ growth influence the PE ratio of any company. The widely reported earnings that we consider for investing purpose are usually based on the trailing 12-month earnings or net income. Basically, as the earnings improve, the PE becomes more attractive. What can drive earnings is a combination of factors such as increased sales, launch of new products, monopolistic products, entering new geographic markets, improving cost efficiencies and putting more cost controls in place, industry sales data and profit margins, management outlook, etc.
It is observed that the PE multiples most likely remain at or near their historical or industry levels for those companies that meet market expectations on the earnings’ front. Most of the times even when the earnings beat the market expectations modestly, the PE multiples hover around the historical levels. However, when there is consistent decline in earnings’ growth or de-growth in earnings, the PE contracts for such companies. In cases where the PE contracts, we see maximum wealth destruction. Maximum wealth is created in those counters where there is steady PE expansion – of course backed by unexpectedly strong earnings’ reports.
PE expands as more and more investors chase stocks with high earnings’ growth. It is prudent to consider a stock overvalued when it is trading substantially above the historical high PE ratio or the market PE ratio. Value investors almost always avoid these kinds of stocks while momentum investors almost always embrace such high PE stocks that are considered overvalued by value investors. High PE stocks are usually the ones with higher growth in earnings and showcasing high earnings’ momentum.
Factors Impacting PE Multiples
1. Market Sentiment: Market sentiment is that powerful intangible that makes stock prices volatile. It is almost impossible to quantify the damage caused or premium gathered due to market sentiments. For sure the market highs and market lows are made due to this single factor called market sentiment. It is observed on many occasions at a single piece of relevant news may disproportionately impact the fortunes of a stock because of the herd mentality. The news will influence the stock prices but the market sentiment will push stock prices further in the same direction, thus leading to premiums and discounts.
With positive news impacting the stock prices, bullish market sentiment can create overreaction, often leading to a premium in the markets. Such premium valuations have tendencies to expand PE multiples beyond reasonable levels. Wealth is created in the process; however, with bullish market sentiment the market tops will lure a lot of gullible investors to take risky bets on the price movement. Thus, PE multiples reveal lot of information to the investing public that can help avoid financial accidents.
"If we avoid the losers , the winners will take care of themselves." - Howard Marks
2. Inflation Level: Higher inflationary environment sucks in the liquidity and interest rates also could be higher. Such a low liquidity situation creates deep discounts in the market and the PE levels usually are on the lower side. On the contrary, when the inflation levels are low and interest rates are low, the liquidity in the system pushes the stock valuation higher, thus creating premium valuations. Low inflation level creates additional liquidity and with additional liquidity the valuation premium increases, which leads to higher PE multiple.
What seems too high and risk to the majority generally goes higher and what seems low and cheap goes lower. -William O'Neill
3. Economic Conditions: In general, when the economic conditions are good the stocks are priced in attractively. Good economic conditions would mean healthy aggregate demand in the country along with adequate money supply. These could be instances of rising exports, factories running at full capacity, investments rising at the country level and corporates reporting outstanding profits in general. Such economic conditions are conducive for premium equity valuations i.e. higher PE multiples.
Conclusion
PE matters and it is important to keep a close tab on the PE multiples before investing, but what matters more is to understand the reasons that drive the PE multiples. Once the investors are focused on the reasons that drive the PE multiple as discussed in this article, the investing process can be more rewarding and less confusing while investment decisions will be more profitable. Amongst all the factors that can be identified for premium valuation behind high PE companies, the quality of corporate governance is a crucial factor. Usually, an independent investor will find it difficult to ascertain the quality of corporate governance by himself. It is very important to focus on corporate governance before taking an investment decision.
Investors should not form any bias against or for low PE stocks and or high PE stocks. A company with great earnings’ outlook, potential monopolistic product pipeline, scope to enter new geographies, and in possession of latest technologies that can bring in cost controls and efficiencies while also helping it to penetrate an existing market is a prime example of a stock that can be a part of any diversified portfolio. For such companies the PE should not matter. Pidilite, Nestle, HUL, Asian Paints, Berger Paints are just some of the companies that fit the bill. Such companies are not to be judged on the high PE levels but on the fundamentals, consistent growth story, and new product launches and earnings outlook.
At the same time, investors have to avoid new names or unfamiliar names with no track record of consistency in sales and profit growth. There are several companies in the listed space, especially small caps and mid-caps, which show sudden spikes in earnings. Such sudden spikes in earnings make these counter attractive for a short while but then what follows is disappointment. There is no follow through in the earnings’ growth. Investors have to avoid investing in such counters as one may end up investing at multi-year highs in the counter and may never see those price levels again even after years of investing.