If you are an investor in any asset, one of the things which are important to know before buying an investment is – how expensive OR cheap its price is. And this is relevant not only for Shares, but any investment category, be it Bonds, Real Estate, Fixed Deposits, etc. After all, if you pay too much for even an excellent investment option, you may have substandard returns and vice versa. For the sake of this post, we would stick to Equities (Shares) as an example.
Price Earning or PE ratio is one of the metrics which is commonly used by investors to identify if a stock is trading at a reasonable valuation. PE ratio of a Company can be derived by dividing the Price of a Company’s stock by its Earning Per Share. Both of these details are readily available on business or trading / broking websites.
Let us take an example of two private sector bank in India – HDFC Bank and Indusind Bank.
|HDFC Bank||IndusInd Bank|
|A. Stock Price (31 July 2020)||1050||520|
|B. Earning Per Share||52||49.72|
|C. PE Ratio (A /B)||20.25||10.45|
If one reads literally into the PE ratio, it could have following interpretations :
a. For HDFC Bank it will take 20.25 years to earn an amount equal to its share price, assuming it earns Rs. 52 per year. Similarly, IndusInd Bank will take 10.45 years to earn an amount equivalent to the share price.
b. If all other factors such as quality of the business, possible future growth rates, goodwill, etc. are same, IndusInd Bank seems to be valued at roughly half the value of HDFC Bank and hence is a better investment proposition.
When can PE (numerically) go up or down ?
Considering PE is a simple formula with Price of a Company as its numerator and Earning Per share as denominator, following set of events can impact a PE ratio.
While the above image tries to simplify the PE ratio analysis in to four quadrants, there can be even more multiple variations. However for simplicity, we would be sticking to these four situations only.
Quadrant A – If an Increase in Price is fully supported by an Increase in the Earnings, the PE ratio should be in healthy zone. In real life if the Company has a strong future growth projection, the Price may grow faster than Earnings in short run as the investors would hope that Earnings will catch-up shortly to justify higher valuations.
Quadrant B – This is a value zone where the price has gone down while the Earnings are still strong. These bargain opportunities come from time to time where Companies may shift from Quadrant A to B for durations of time, for example in case of Nestle when it faced a sharp price correction owing to Maggi ban in 2015. Another possible case could include particular sector which is out of flavour for investors despite of healthy earnings. In mid – 2020, this could point towards many of Energy Companies.
Quadrant C – Things starts to become a bit riskier for Companies in this zone and are often confused by investors as Quadrant B value companies. Here the price is going down, but so are the earnings. Investors need to look into do a deep dive into the reason behind earnings collapse and if this could point towards permanent or long term degradation in the business performance. 2020 had lots of such examples coming into play, trapping lots of investors, e.g. Yes Bank.
Quadrant D – It is here where we have a bubble zone and speculative traps. The price tends to shoot up without any fundamental earnings to support. At times investors may consider this as too many promise about future growth, but it is a bubble zone waiting to be busted. One specific example which comes to my mind is of Ruchi Soya whose stock price shot up INR 20 levels at the start of 2020 to INR 1500 levels by end of June and within a month back to INR 650 levels. On the other hand, this zone also houses most of the futuristic Companies which are yet to come up with Good earnings and hence the stock prices are reflecting the optimism. An intelligent investor would assess each of these Companies carefully before taking a plunge.
With our example of HDFC Bank and IndusInd Bank, investors could consider HDFC Bank as either a Quadrant A or D, depending upon how much it is supported by its Earnings. Similarly, IndusInd may appear to be either Quadrant B or C in comparison to HDFC Bank. If an investor considers it to be a Quadrant B value buy and it ends up being a Quadrant C ‘Value trap’, then it could negatively impact the future returns. Hence it is critical to assess PE ratio with the driver behind it, i.e. Earnings.
Is High PE Ratio Company an Avoid ?
The answer to this question is very much dependent upon the underlying growth and quality metrics of the business. One must remember, PE ratio is a ‘relative’ ratio and needs to be assessed in comparison with the PE ratio generally operating in the Geography, Industry and peer group Companies. Also, higher the quality of a Company, the market would prefer to honor it by awarding it a higher valuation, i.e. higher PE. For example, a PE of a good banking Company could be in upwards of 20+, a FMCG Company at 60+, while a metal / mining Company may have a PE of less than 10.
Let’s see this via our continued example of HDFC Bank and IndusInd Bank.
In the chart below, you will see the stock price of HDFC Bank from 2014 (INR 400) to Jan 2020 (INR 1170). Price can only tell that the Company is apparently growing and hence its share price has gone up.
There are two subtle running charts below the price chart. You will notice that the Rolling Earning per Share (EPS) has consistently gone up from sub 20 levels to 50 during the same time.
Despite of a 4X price move in 6 years time frame, the PE ratio has stayed within a range of 20-30 (interestingly, at the start of year 2020, the PE ratio of HDFC Bank is around the same as it was in 2014). This is clearly pointing towards that the price movement in HDFC Bank was fully supportive with Earnings increase.
IndusInd Price went up from 550 to 1100, i.e. 2X during the same period. Its PE ratio at the start of the period was around mid 20, ending in Jan 2020 at with roughly 17’ish, i.e. a PE contraction. Would this make IndusInd more attractive on valuations front ? As we mentioned above, PE is a relative concept and perhaps the markets like HDFC Bank’s robust risk management and quality of its loan book which are not evident in just looking at the PE ratio and the earnings number.
Factors which drive PE
While screening investment options, investors should consider following key factors which drive the PEs (both for high and low), most of them driving the ‘EARNINGS’:
- Earning Forecasts – Positive earnings forecasts can make Price run up before Earnings coming to match it. Viceversa, in expectation of lower earnings in the future, Prices may correct even before poor earnings start coming in.
- Consistent track record of revenue growth with profitability gives investors more comfort of future success and hence giving more support towards higher PE.
- Environmental & health sustainability is an increasingly attracting investor’s preference. A Company having a negative impact on health or environment may not attract investors and hence lower prices despite of higher earnings. Examples include Cigarette Companies despite of being extremely profitable, don’t quote at high valuations;
- Governance Standards – Time and again it has been proven that if a Company is tainted by a management who has a track record of not caring for minority shareholders or has been in the spotlight for malpractices, such Companies are extremely disliked by investors. A topic which goes hand in hand with Governance is how transparent a Company is in its disclosures and Annual Reports. Good Governance will attract investors like honey bees.
- Robust Risk management – this is particularly important for Financial Services Companies where poor risk management standards can result in hefty losses. Gold standard risk management practices gets a lot of comfort to the investors who are ready to pay a higher price for such Companies.
- Technology & Innovation – Considering the scale and frequency of disruptions, an innovative Company which continuously enhances its product offerings and enhances its processes will be liked by the Community. Using right technology will help drive efficiency, increase scale and manage costs. You may see most of the Tech and innovative Companies (e.g. TESLA) quote at astronomical valuations.
In summary, while PE ratio is a critical metric is helpful in identifying how costly a Company is, it must be analyzed with multiple other metrics impacting the respective business. Higher the profitability, consistency quality of a Company (including Governance ethics), environmental and health sustainability, higher the PE it can command as a ‘normal’ (and viceversa). In longer run, it is not how expensive which tends to be the driver of the price of stock, but the underlying earnings growth. Hence an intelligent investor would look into the PE of a Company along with its linked ‘EARNINGS’ metrics while screening the investment options.
We would like to endthe blog post with a food for thought. As of July 2020, Fixed Deposits are getting approximately 5.5% returns or a PE of 18. In other words, it will take around 18 years to earn that much interest equal to the amount put in the FDs.
To help in explaining the details in this post, we have used specific illustrative Companies. None of these should be construed as an investment advice to buy or sell. We may hold such Companies in our portfolio.