By Vikash Agarwal
When it comes to valuing stocks, price/earnings ratio is one of the oldest and most frequently used metrics. Although a simple indicator to calculate, the P/E is actually quite difficult to interpret. It can be extremely informative in some situations, while at other times it is next to meaningless. As a result, investors often misuse this term and place more value in the P/E ratio than is warranted.
P/E is short for the ratio of a company’s share price to its earnings per share. As the name implies, one has to take current stock price of a company and divide it by its earnings per share (EPS) to calculate P/E.
Most of the time, the P/E is calculated using EPS from the last four quarters. This is also known as the trailing P/E. However, occasionally the EPS figure comes from estimated earnings expected over the next four quarters. This is known as leading or projected P/E. A third variation, which is also seen, uses the EPS of the past two quarters and estimates of the next two quarters. There isn’t a huge difference between these variations. But it is important to realise that in the first calculation, you are using actual historical data. The other two calculations are based on analyst estimates that are not always perfect or precise.
Companies that aren’t profitable, and consequently have a negative EPS, pose a challenge when it comes to calculating their P/E. Opinions vary on how to deal with this. Some say there is a negative P/E, others give a P/E of zero, while most just say the P/E doesn’t exist. The P/E can also vary widely between different companies and industries.
Theoretically, a stock’s P/E tells us how much investors are willing to pay per rupee of earnings. For this reason, it’s also called the “multiple” of a stock. In other words, a P/E ratio of 20 suggests that investors in the stock are willing to pay Rs 20 for every Rs 1 of earnings that the company generates. However, this is a far too simplistic way of viewing the P/E because it fails to take into account the company’s growth prospects.
Although the EPS figure in the P/E is usually based on earnings from the last four quarters, the P/E is more than a measure of a company’s past performance. It also takes into account market expectations for a company’s growth. Remember, stock prices reflect what investors think a company will be worth. Future growth is already accounted for in the stock price. As a result, a better way of interpreting the P/E ratio is that it is a reflection of market’s optimism concerning a company’s growth prospects.
If a company has a P/E higher than the market or industry average, this means that the market is expecting big things over the next few months or years. A company with a high P/E ratio will eventually have to live up to the high rating by substantially increasing its earnings, or the stock price needs to drop.
The P/E ratio is a much better indicator of the value of a stock than the market price alone. For example, all things being equal, Rs10 stock with a P/E of 75 is much more “expensive” than Rs 100 stock with a P/E of 20. It’s difficult to determine whether a particular P/E is high or low without taking into account two main factors:
- How fast has the company been growing in the past, and are these rates expected to increase, or at least continue, in the future? Something isn’t right if a company has only grown at 5 per cent in the past and still has a stratospheric P/E. If projected growth rates don’t justify the P/E, then a stock might be overpriced. In this situation, all you have to do is to calculate the P/E using projected EPS.
- It is only useful to compare companies if they are in the same industry. For example, utilities typically have low multiples because they are low growth, stable industries. In contrast, the technology industry is characterised by phenomenal growth rates and constant change. Comparing a tech company to a utility is useless. You should only compare high-growth companies to others in the same industry, or to the industry average.
In the right circumstances, the P/E ratio can help us to determine whether a company is over or under-valued. But P/E analysis is only valid in certain circumstances and it has its pitfalls. Some factors that can undermine the usefulness of the P/E ratio include:
Earning is an accounting figure that includes non-cash items. Furthermore, the guidelines for determining earnings are governed by accounting rules that change over time and are different in each country. To complicate matters, EPS can be twisted, prodded and squeezed into various numbers depending on how you do the books. The result is that we often don’t know whether we are comparing the same figures, or apples to oranges.
In times of high inflation, inventory and depreciation costs tend to be understated because the replacement costs of goods and equipment rise with the general level of prices. Thus, P/E ratios tend to be lower during times of high inflation because the market sees earnings as artificially distorted upwards. As with all ratios, it’s more valuable to look at the P/E over time in order to determine the trend. Inflation makes this difficult, as past information is less useful today.
A low P/E ratio does not necessarily mean that a company is undervalued. Rather, it could mean that the market believes the company is headed for trouble in the near future. Stocks that go down usually do so for a reason. It may be that a company has warned that earnings will come in lower than expected. This wouldn’t be reflected in a trailing P/E ratio until earnings are actually released, during which time the company might look undervalued.
