P/E atlast....

Lets forget the stock markets for now, and just look at a company,
where you may consider investing. Say, the company has given out 1000
shares. And this company makes a profit of Rs. 10,000. Very simply
put, if this profit had to be distributed to individual shareholders,
how much would each shareholder get? Rs. 10, right? Well, then Rs. 10
becomes the 'earnings per share" or EPS as it is known.

Now if there is someone owning a share of this company, and he wants
to sell it to you. What will be the minimum price that you will be
willing to pay? Well, it has to be Rs. 10 again, as that is the
'earnings per share' and conceptually that amount is yours for the
taking. So indeed the minimum price that you will be willing to pay
for the share is Rs. 10.

However, note that you are going to become a shareholder by purchasing
this share, and you will not just get the fruits of this year's
earnings, but of future earnings of the company as well. So you may be
willing to invest a little more than Rs. 10. How much more will you
invest? That will depend on your perception of how the company is
likely to do in the future. You may believe that the company may
continue to earn the same amount for at least 3 more years, and you
are willing to take your bets up to that period. Then, you may be
willing to purchase that share for Rs. 30, rather than just Rs. 10. On
the other hand, you may have a feeling that the company is not only
going to make profits for future years, but it is poised to increase
its profits substantially, over the next few years. Say, you may
estimate that the profits will be 3 times the next year, 5 times the
year after, and 10 times the year thereafter. In such a case, you may
be willing to pay a much higher sum for that share, say, even Rs. 100
or Rs. 120, as compared to the original Rs. 10. Whether it is Rs. 30
or it is Rs. 100 or it is Rs. 120, what you are paying is a MULTIPLE
of the present "earnings per share". Remember that in the above
example, the present earnings per share were Rs. 10. When you pay Rs.
30 for that share, you are paying a multiple of 3 times the EPS, and
when you are willing to pay Rs. 120 for that share, you are willing to
pay a 12 times multiple of the EPS.

I trust that you have understood the above. As soon as you nod in
confirmation, you have also understood then, the concept of P/E ratio.
Yes, in the P/E ratio, P stands for the price of the share, and E
stands for EPS or earnings per share. And hence, the P/E ratio is
nothing but the multiple to the EPS that the price commands. When you
were willing to pay a PRICE of Rs. 120 for the share, whose EPS was
Rs. 10, the share had a P/E ratio of 12.

In the real world of companies whose shares are listed on the stock
markets, the scenario is same, but at a larger scale. Instead of the
1000 shares that the company in the above example had, most listed
companies will have lakhs of shares that have been issued. But the
principle of EPS and P/E ratio remains the same.

The other thing to appreciate is that out of the two factors in the
P/E ratio, the "E" part, i.e. the EPS, does not change on a day-to-day
basis. Even though the company operates its business daily, it does
not release it's accounting information on a daily basis, so we only
know the EPS based on the last declared financial results. Also in
reality, the earnings of the company generally move as per some
gradual movement that has already been envisaged and predicted. Large
variations in the EPS are unlikely. So in the ratio P/E, the E part
remains largely steady. It is the P part of the price of the share,
which is dynamic and will tend to change daily or even hourly, based
on the perception that investors have, about the company, and where it
is headed. Change in the price, then gives a change in the P/E ratio.
Or knowing some facts about the company, its present P/E ratio, an
investor could hazard a guess as to its likely movement on the P/E
ratio, and then, you can take an educated guess, whether it's a good
time to buy the stock or to sell it, or to just stay put.

How does that happen? Let me give you some idea of this.

1. Typically an industry sector may have an average P/E. Say, for
example, the 2-wheeler industry has a P/E of 15. Which is nothing but
an average of the P/E of the various industry players. Now, if Bajaj
Auto has a P/E of 14 and Hero Honda has a P/E of 16, what does it say?
It would say that for some reason, perhaps due to the future prospects
that the market perceives, they have given a better appreciation to
Hero Honda stock than to Bajaj Auto. Now if Bajaj Auto comes out with
good results, then there is a good chance that its share price may
rise to make its P/E at least 15, if not beyond that. On the other
hand, for Hero Honda to appreciate further, it must come out with
something more outstanding, and substantial, for the market to give it
a multiple even beyond the premium that it has already given to the
stock. Moreover if there is any adverse news about Hero Honda, the
stock is likely to slip sharply to levels where its P/E goes down to
15 or 14 (Bajaj Auto's level) or maybe even lower than that.

2. There is a chance that due to some bad years of performance, in an
industry sector, a particular company has got badly hit, in terms of
its share price. Where the industry average P/E is say, 15, this share
price has been hit so badly, that its P/E is dwindling at 5. Now
suppose there is news that due to some restructuring or whatever, this
company is turning around in its performance. And if it is believed
that it will soon come close to the rest of the industry peers, then
just imagine the room that this stock has to grow. Since its P/E is
only 5 and the industry average is 15, then the price can move
significantly up, before its P/E level reaches somewhere close to
12-15. That may suggest a great buying opportunity then. This, in
fact, is what has happened to many PSU companies whose shares are
quoted on the stock market. PSU banks' stocks are also examples of
this type.

3. The P/E ratio also explains the astronomical rise of some stocks in
the 'new-age' industries like say, IT, Media, Biotech, etc. The market
somehow believes that the earnings of these companies will rise at a
very fast pace, as compared to more traditional old economy companies.
Which means that over the years, the "E" part of the P/E ratio is
going to keep going up rapidly. That being the case, the market
pre-empts the scenario and gives a big premium of the price multiple
today itself, and that results in a high P/E ratio. The IT industry
commands a P/E of more than 50, the pharma industry commands a P/E of
around 32 and the FMCG industry (on account of the expected growth in
this sector due to the large buying power of India's middle class,
perhaps) has a P/E of around 34. This is compared with P/E of 18 for
cement industry, 10 for engineering industry, and 6 for Power sector
companies. You can well see what the market believes about the future
prospects of these industries. By the way, all this information of P/E
for individual company or for an industry sector, is available on the
website of equitymaster.

4. Sometimes when our stocks are rising to great heights, we may
question the logic for the same? Do these stocks justify such a price
level? One way to validate these doubts is to again look at P/E
levels. What is the average P/E in a developed market like the US
stock market? What is the average P/E level in some other emerging
markets, like say, Brazil? What is the P/E level say, for the leading
bank stock on the Wall Street? How does that compare with the P/E
level of India's leading bank stock, State Bank of India? Comparisons
of this nature can give us answers as to whether our markets are
overheated or in fact, they are slowly catching up with the world, in
terms of the P/E multiples that we have given. The latter may point to
a maturing of the markets, in fact. To give you the actual answer,
indeed, our markets are maturing, and our P/E levels on an average
have been lower compared to the better markets of the world, and in
fact, there is still a lot of room to catch up with the world P/E
multiples. Again then, if we believe that the India story is
happening, we should not be surprised that our stock prices are
rising, as we are only closing in to the P/E levels commanded in other
world markets.

5. A note of caution about understanding P/E. Where the above
guidelines are theoretically correct, there is a question of
understanding what data you are seeing. You may see an EPS of a
company today. Do you know clearly, if that EPS is of April 1, 2004
results, or based on quarterly results for quarter ended on December
31, 2004 or in fact, these are the projected EPS for year ending 31st
March 2005? When you compare P/E for different companies or in an
industry sector, are you sure if the EPS taken for comparison is the
same period one, for both? There are times when analysts refer to
"forward P/E", there are times when the P/E is based on last year
ended results, etc. It is important to be clear of the data behind the
P/E ratio to ensure that the correct comparison is made, and action
taken based on the data, is also correct.

Yes, it is a technical issue that we have covered this week. Those of
you who are able to understand and utilize this understanding well,
will have an additional weapon to combat the markets. Those who choose
to let it pass, are also okay, as the earlier discussed principles
which are simpler to understand, will still carry you through the
minefield of the marketplace!

Till next week, then. Take care….
Sanjay Mehta