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Economy & Finance
Price
Earning Ratio
In the last few years Price
Earning (PE) Ratio has become the most important figure for investment decision
making in the stocks of companies. The old tool of valuation, namely the Book
Value has been considered outdated. In today’s knowledge based business era, PE
has emerged as the most influential number for decision making for the savvy
Institutional investors. The retail investors are also gradually getting
influenced with it.
PE means the ratio of the stock
price of the company to its earning per share (EPS). Earning per share is the
amount, which each share of a company has earned in a year. In the earlier days
of stock markets in India, the face value of the shares of most of the companies
was Rs. 100/-. Then started the trend of face value of Rs. 10/- per share. Since
last few years, the companies are allowed to decide their own face value of
shares and they can consolidate or sub-decide their shares easily. Many
companies, which are doing well on the stock market and quoting at very high
prices, have subdivided their shares. Now, the listed companies have a range of
face values in rupees such as 1, 2, 5 and 10. It is important to know the face
value of a share of a company before investing in it. A share may appear to be
cheaper than others just because its face value is reduced to Rs. 1 or Rs. 2
while the others in comparison may have face value of Rs. 10/-.
PE ratio indicates as to how
many times of the current earnings per share of a company, its price is being
quoted on the stock market. Higher the ratio apparently more expensive the stock
is. The PE keeps on changing daily as the stock prices change daily. Though the
numerator of the ratio changes daily; the denominator changes generally once a
year when the profits for the financial year are declared. However, annualised
data is found to be stale by savvy investors and there is a trend to work out
earning per shares on the last four quarters basis which can give realistic
current figure of earning per share as compared to historical annual earning
based on financial year.
Generally it is believed that
higher the PE, expensive is the stock but PE cannot be considered in isolation.
Number of factors can influence the analysis of PE by investors. For some
stocks, the market, year after year, justifies and accepts high PE. For some
other stocks, it is low year after year. Some of the factors considered to be
influential for evaluation of PE are as under.
PE of the industry
The fund managers of High
Net-worth Individuals (HNI) and Institutional investors have great depth of
knowledge about the industry. They compare the PE of a stock with the PE of the
other stocks in the industry. Typically for companies in the business of
commodities such as cement, sugar, steels, etc. the industry PE is considered
very relevant. When the market for a commodity is rising, higher PE becomes the
norm for the company in the industry. When recession starts in such industry,
the average PE for the whole industry comes down due to lower future
expectations. A stock may have low PE based on the future of the industry; but
it may have high historical Earning per share (EPS). Still, the EPS should not
be a motivator for the investors to invest in such a stock. Shares of a
reasonably reputed company in the industry quotes around the mean of PE of the
stocks in the industry. The industry leader quote at higher PE than the other
stocks in the industry.
PE of the peers
PE of a stock can be influenced
by the peer stocks. Though many companies may be in the same industry, there can
be certain companies, which are considered as peers. They are generally
contemporary to each other in many ways. To illustrate, in the universe of
banking industry in India the nationalised banks are considered as a peer group
and newly established private banks are considered as a different peer group.
The stocks in their peer groups respectively quote at different PE though they
are from the same industry. Similarly, in software space, large companies, which
also have BPO operations are considered as peers and their PE is much higher
than the PE of an average software company.
PE of the market
When the Financial
Institutions, which are global players, take their decision of entering and
investing in the stock market of a newly emerging economy, they are influenced
by the PE of the whole market. The asset allocation to such an economy is also
influenced by PE in similar emerging markets. The PE of the market is the
weighted mean of the PE of the leading shares generally constituting the index
of that market. PE of the Indian stock market can be considered as mean of PE of
all stocks in Sensex or PE of all stocks in NSE 100. Funds of FII flow from
market to market based on the PE of the market. Once the funds are allocated to
a market, an individual stock is selected based on its merits. When an investor
is talking about market being expensive or cheap, he is actually referring to
the PE of that market as compared to fair PE as per his own understanding of the
market.
PE to growth
Generally, higher the PE more
expensive is the stock. However, fast growing companies do command much higher
PE than others companies. Their stocks always look expensive, but over the
years, the appreciation of such stocks is more than most of the others. This is
the reason for which the stocks of fast growing software, pharma, engineering
and FMCG companies command high PE. When an investor is investing in the stocks
of a company in spite of its high PE, he is admiring the fast growth and bright
future of the company. The thumb rule is that if the expectation of growth rate
of a company is higher than its current PE, the stock is not expensive. This is
the reason why extremely high PE of software companies and some private banks
are sustained year after year in India. These are the high growth stocks, which
look expensive all the times. Small investors stay away from them and the large
investors make killing out of them.
PE to interest rate
Higher rate of interest can
result into lower corporate profits and lower earning per share, which can
increase PE on a short-term basis. However, the market adjusts by reduction in
the price of the stocks, which can reduce their PE. Over a long period, high
interest rate depresses the PE.
The term PE is reverse of the
ratio of income yield. Yield is the ratio of earning to price as against price
to earning. In the high interest regime, interest yield is high and the
expectations of profits should be higher to attract investors. PE is generally
low in the market where high interest rate prevails. In the market with low
interest rate high PE ratio can be supported.
Conclusion
Though PE multiple is one of
the most effective bench marks to find out how cheap or expensive is the stock
market, it has to be viewed with caution. An investor should understand the
direction of the stock market, the industry and the economy to conclude that the
PE for a stock or that of the market is reasonable.
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