INVESTOR EDUCATION SERIES
PRICE EARNINGS RATIO
A GOOD METRIC
TO ASSIST STOCK BUYING
TO ASSIST STOCK BUYING
One of the most important ratios that can enable Investors to make their investment decisions is the PE ratio, or, the Price Earnings ratio.
It is calculated as :-
(Market value or price per share) divided by (Earnings Per share).
Market value or price differs from moment to moment when market is open, so, usually, the END OF THE DAY price is taken. For calculating P/E Ratio for the year end, the Price in the market at the close of the last day of the year can be taken as guidance. However, if this price was too much of a speculative nature and was either too low or too high from the normal, average price, we may even take the average price of the day. The intention is – it should represent a fair market perception of the value of the stock on the day. Market value goes on differing from moment to moment and from day to day, based on demand and supply and other market related factors. This upward or downward moment of the price necessitates constant review of the PE Ratio.
Earnings per share is usually taken as the immediately preceding Financial Year’s Earnings per share. This is usually available in the auditor-certified annual accounts and can be adopted for day-to-day calculation in the year which follows, with reference to the immediately preceding Balance sheet and accounts..
CALCULATION
Let us consider the example of HDFC company. Let us assume that all figures taken herein are arbitrary, purely for understanding the concept of PE Ratio – though, some of the actual figures of the company may also have been taken herein.
The Face value per share of the company is Rs.10.
The Basic EPS (cumulative, consolidated)for the FY 2010 is Rs.113.33 and Rs.81.09 for the FY 2009.
Let us assume that the share was quoting at Rs.2650 before announcement of the FY 2010 results and there was no way for the market to forecast the likely EPS of FY2010, whether upward or downward.
So, market has assigned a price of Rs.2650 for HDFC share.
On the basis of the price of Rs.2650 per share and the known EPS for FY 2009 of Rs.81.09, the PE Ratio can be calculated as : Price Of 2650 / EPS of 81.09 = PE Ratio of 32.68.
On announcement of the results, we find the EPS has actually gone up to 113.33 in FY2010.
Let us say, the share price has immediately risen from 2650 to around 2800 in a few trading sessions based on the improved EPS / results.
Today, PE Ratio is (Price 2800 / EPS 113.33) = PE 24.71. It is no more equal to the old PE Ratio of 32.68.
Some questions arise now and need answer.
(1)Why did the market give a huge price of Rs.2650 when the EPS known was only 81.09, which made it a high priced share at a PE ratio of 32.68? One explanation is – market really had made some guesswork of the better performance of the company and the likelihood of much better results. So, the higher price earning ratio was given.
(2)Why did it not give Rs.2800 price before results were declared? It is simply because; market is unaware of the exact level of progress in EPS that the company has made in the year.
(3)After declaration of results indicating an EPS of 113.33, why did the Price not rise to a level where PE ratio will again equal 32.68. In the market’s perception, PE ratio of 24 to 25 may be more valid at this date. In Fact, the EPS of 113.33 was very much there even before declaration of results but was just not known to market or hidden from the market’s eye. It was left to the guess work of the market. Hence, market price was hovering round Rs.2650. Once the correct annual EPS was known, the price raced up to Rs.2800 to adjust the price earning ratio to around 24 – 25.
(4)Will it ever reach a PE multiple of 32 again? It may. For that let us take a look at the last quarter’s EPS, instead of the full year’s EPS. The last quarter (OCT-DEC 2009) EPS was 32.24, up from Rs.23.47 in the previous quarter. The trend in last 4 quarters of FY 2009 was a rising EPS on the back of rising sales income. Now, even if the same 4th quarterly EPS is repeated without increase in all 4 quarters of FY 2010, current year EPS will be around 128.96 (or, 32.24 x 4).This is more or less certain. Now, let us given the PE multiple of 24 only, to this EPS estimated by us for the full FY2010 year.
(5)That is , EPS 128.96 x PE 24 = PRICE 3095.04. This is the likely price which HDFC can touch during the Current FY2011.
(6)But, the EPS known to day is only 113.33. The EPS estimated by us is 128.96. A price of 3095 means PE multiple of 27.31 (3095/113.33).
(7) The above estimate is a little imperfect. Suppose, 2 quarters down the line, we find that the EPS for the 1st 2 qtrs was not 32.24 each , but 36 and 44, we will again need to recalculate the EPS for the full year at (36+44) x 2 half years =176. This again gives rise to higher price in the market. i.e., EPS 176 x PE 24 = 4224.
(8)So, while EPS known is always a trailing EPS, as per audited accounts, Market price depends not only on past EPS but also expectation of future earnings.
(9)There is no particular reason why we are adopting the P/E ratio of 24. For high growth companies, a PE of 24 or even higher is seen in the Indian context, especially when market is in growth phase. When market is in down trend, even a PE ratio of 12 may be reached. We also find such ratios in American and other markets.
(10) We have talked of a high growth, successful company in the above example.
(11) But, there are low growth Industries and low growth companies. Low growth Industries command lower PE ratios. Likewise, Low growth companies command lower PE ratios.
(12) There are some High growth companies in Low growth Industries, whose P/E ratio may be more than the other companies in the Industry but still may not be equal to High growth Industries.
(13) Like wise Low growth companies in High growth Industries some times command higher valuations – due to the general perception of the Industry, but still, it will be less than the High growth companies in the same Industry.
(14) There are low growth companies in Low growth Industries. Evidently, they command the least valuations or PE ratios.
(15) What other factors affect PE ratios? Perception about the quality of the Management, Government patronage, customer patronage, product quality, scientific advancements affecting the products of the company, court cases pending against the company – and so many other factors can affect the PE ratio of the company.
(16) Bring in a reputed CEO. Market assigns a higher PE ratio to that company instantly.
(17) Currently, Reliance PE ratio may be lower than market perception – due to the court case.
(18)TCS and INFOSYS PE ratio may have become lower due to dollar-rupee exchange fluctuations.
(19)Let us also face the fact- PE ratio by itself does not tell the whole story. The PE ratio may be lower due to lack of knowledge of the market about the real strength of the market. All markets are imperfect. There are always communication Gaps.
(20)That is why – many investors hunt for GEMS among the low PE companies. When you find one – you may have to wait till market discovers it – which will happen sooner or later. But the early discoverer will become a sudden, huge beneficiary. We may discover such GEMS – among what are called PENNY STOCKS. They are of course risky. Only a highly experienced analyst, with good knowledge of the industry and all factors connected with the company - can spot a real GEM among penny stocks.
(21)There are many other factors connected with PE ratios, which will be discussed in some future Blog Posts.
(22)Readers are invited to offer comments, ideas, criticism or corrections – which will be gratefully taken note of.
Other Articles in CUSTOMER EDUCATION SERIES can be read at the following URLs :
1. MONEY FASCINATES:
2. MARKET INVESTMENT : ESSENTIAL RULES FOR SUCCESS:
3. SELECTING A GOOD SCRIP FOR INVESTMENT
4. INVESTMENT STRATEGIES OF WARREN BUFFET: (5 ARTICLES)
6. WORDS OF WISDOM FROM WARREN BUFFET:
7. DOLLAR (RUPEE) COST AVERAGING
:
8. PRICE TO EARNINGS RATIO : ( CURRENT BLOG POST)
9. GROWTH STOCKS vs VALUE STOCKS :
10. CANSLIM TECHNIQUE :
11. PRICE TO BOOK VALUE RATIO
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