In this blogpost
I try to help my readers understand one of the most popular profitability
ratios of all time; the Price to Earnings Ratio or as is popularly known as the
PE ratio. With the disproportionately high focus that PE multiples have
attracted over time, it is important for every investor to understand whether
this valuation metric really lives up to the hype surrounding it.
So what does a PE ratio tell you, and more importantly
what it doesn’t?
A PE ratio gives
us the relationship between the current market price of a company’s share
relative to the earnings it generates per share. Here’s the formula:
P/E = Current Market Price of a Share / Earnings Per
Share
In other words,
a PE ratio tells us what the market is willing to pay for every rupee of
earnings generated. For instance, if a company ABC is trading at a PE of 25, it
means that participants are willing to pay Rs.25/- for every Re.1 earned. However,
the PE ratio, is often loosely interpreted by many, to determine whether a
company’s share is undervalued, fairly value or overvalued. While there’s no
universally accepted benchmark PE figure; comparisons are drawn based on where
the company’s peers stand, the industry average and the company’s own
historical PE.
The Price to
Earnings Ratio is one of the most commonly used measures of relative valuation
across the globe. However, as with any other relative valuation measure, A PE
ratio looks at the value of an asset relative to other similar assets traded in
the market, but tells very little about the real value of the asset.
Let me demonstrate this with the help of an example.
Consider two Companies
ABC ltd. & XYZ ltd. in the same industry. Let’s say ABC is trading at a PE
of 25 while XYZ is trading at a PE of 40. Let’s say both companies generate the
same earnings. Going purely by traditional wisdom on PE ratios, one would be
tempted to believe that ABC, given its lower PE is comparatively undervalued
than XYZ. However, when digging deeper into the companies’ fundamentals, one
realizes that XYZ is far more capital efficient and is able to generate the
same earnings as Company ABC, but at a far lower capital requirement than
Company ABC (let’s say in this case the capital requirement for XYZ is 50% lower
as compared to Company ABC). In other words, XYZ is twice as capital efficient
as ABC. This means that the earnings growth generated by XYZ will be double for
the same level of capital employed. Seen in this light, the PE commanded by
Company XYZ is quite justified. Thus the argument “Low PE = Better Value” falls flat in this case.
In fact, many of
the high growth companies command a Higher PE; higher capital efficiency being
one of the reasons. Similarly, in many cases companies trading at very low PEs
could actually be trading at low multiples for a reason and might well deserve
being traded at a low PE. While visually high PEs could blindside us to the
many potential investment opportunities that come our way, low PEs on the
contrary could create an illusion of value, leading uninformed investors
inadvertently chasing an investment value trap. Thus blanket generalizations
based on PE ratios alone may end up giving a misleading picture of the company’s
value. A PE multiple should therefore, at best, be one of the many tools to aid
you in your valuation process and not a core valuation metric in itself.
So stop fixating on PEs and look at a company for what
it is really worth!
About the author
Deepak Rameshan,
CERTIFIED FINANCIAL PLANNERCM, Dip TD, MMS
Deepak Rameshan, CERTIFIED FINANCIAL PLANNERCM, Dip TD, MMS.
Deepak Rameshan is a CFPCM professional, and has been working in the financial services domain for close to 13 years. He holds a Master’s Degree in Management Studies and a Diploma in Training & Development and has been actively engaged in Training & Content Development during this period. As a Personal Finance Enthusiast and an avid researcher of the subject, Deepak has delivered several Investor Awareness Workshops over the years covering areas such as Risk Planning & Insurance, Retirement & Goal planning, Tax Planning and a few other specialized areas. He takes keen interest in writing and has penned numerous articles for this blog, addressing some of the most relevant concerns that individuals face with respect to their finances.
“Financial Planning Standards Board Ltd. (FPSB Ltd.) is the proprietor of the CFPCM, CERTIFIED FINANCIAL PLANNERCM and marks outside the United States, including in India, and permits qualified individuals to use these marks to indicate that they have met FPSB Ltd.’s initial and ongoing certification requirements.”
Watch this space for more insights on Personal Finance…