Don't Waste Your Time On PE: Focus On The Business Instead

Currently, the market’s PE ratio might appear elevated when viewed in isolation. However, when considering other critical parameters like the earnings’ cycle, price-to-book value, market capitalisation to gross domestic product (GDP) ratio, and more, the landscape differs from the previous market peaks. Taking all this into account, Bhavya Rathod highlights the fact that the PE ratio alone is not enough to drive investments 

As we witness another phase of correction following the recent highs, the age-old discourse surrounding valuation re-emerges. However, before you contemplate altering your investment allocation in response to whether the market appears overvalued or undervalued, it’s crucial to grasp precisely which valuation metrics merit your attention. One such metric that can provide valuable insights into this intricate puzzle is the price-earnings (PE) ratio. The PE ratio is a financial metric that boils down to a simple equation: It takes the current market price of a stock, which represents what you are willing to invest to acquire it, and divides it by the earnings per share (EPS), which denotes your earnings for each share you hold. 

Essentially, the PE ratio serves as a measure of the price you are prepared to pay for a company’s annual earnings. For instance, if a stock boasts a PE ratio of 20 times, this signifies that for every unit of your currency (as for example, ₹ 1), you are willing to allocate ₹ 20. However, it’s crucial to note that this price doesn’t solely reflect the actual earnings. Rather, it conveys your anticipation of the company’s annual earnings growth. A high PE ratio indicates heightened expectations of robust earnings growth in the upcoming year, while a lower PE suggests a more conservative outlook in this regard. Furthermore, as an investor, it’s essential to acquaint yourself with two key variations of the PE ratio: trailing PE and forward PE. [EasyDNNnews:PaidContentStart]

The trailing or historical PE is computed using the earnings’ data from the past 12 months, providing insights into what the company has already achieved in terms of earnings’ performance. On the other hand, the forward PE is derived from estimated one-year earnings projected for the upcoming fiscal year. These estimates can be based on your own assessments of how the company’s profits are expected to materialise, or they can be influenced by the consensus among analysts in the financial community. Notably, the forward PE is a more dynamic metric, susceptible to shifts caused by corporate announcements or external factors that might impact future earnings’ forecasts.  

PE Ratio in Isolation

The PE ratio, when taken in isolation, offers limited insight. To draw meaningful conclusions, it is imperative to contextualise it within several factors: the industry it operates in, its place within a broader investment portfolio, and its historical performance trends. The PE multiple is employed to assess a stock’s appeal concerning its price relative to the broader market, gauged by the PE ratio of the index, as well as in relation to peer companies by comparing it with the average PE ratio within its industry. It’s crucial to recognise that a stock trading at a low PE multiple may not necessarily present an attractive investment opportunity. 

This lower multiple could be a reflection of the market’s assessment of the company’s limited growth prospects, resulting in a less favourable valuation. Conversely, a high PE multiple must be substantiated by robust growth prospects to be considered justified. In essence, the PE ratio’s significance is magnified when examined within the broader context of industry norms, market dynamics, and a company’s growth potential. A high PE ratio should not necessarily deter investors, just as a low PE ratio isn’t always indicative of a favourable investment. The key factors at play are the underlying assumptions and how accurately they align with reality. Valuations in the stock market always have a forwardlooking dimension. 

What this signifies is that investors are willing to pay a current price that reflects the anticipated growth in earnings that a company is expected to achieve in the future. In the present context, as government policy reforms gain traction and macroeconomic factors show signs of improvement, there’s a pervasive assumption that earnings’ growth will rebound sooner rather than later. Consequently, stocks with a clear and foreseeable path to earnings’ growth are witnessing their valuations adjusting accordingly, potentially at a faster rate than companies where earning prospects remain uncertain. Imagine you have a stock initially valued at ₹ 1,200, trading at a forward PE ratio of 50 times. 

However, a market correction unfolds over six months, leading to a 10 per cent decline in the stock’s price, bringing it down to ₹ 1,080. With the earnings’ level staying constant, the PE ratio for the stock has now adjusted to 45 times. In this relatively short period, the stock doesn’t seem as expensive as it did before the correction. Now, let’s introduce the assumption of earnings’ growth for the upcoming financial year. If, for instance, the market anticipates a robust 15 per cent earnings’ growth, the forward PE ratio, at the reduced stock price of ₹ 1,080, drops to 39 times. In this context, a stock that appeared expensive six months ago is now perceived as reasonably priced. Every company possesses its unique valuation metrics. 

One firm trading at a PE ratio of 15 times earnings may appear overvalued, while another could seem reasonably priced even at a PE ratio of 20 times. The key consideration should revolve around a company’s capacity to consistently generate earnings growth over an extended period and maintain a healthy profit margin. In instances where a stock consistently delivers a high return on capital, demonstrates enduring growth over the years, maintains a competitive edge and sustains its growth trajectory, it’s not surprising to witness the stock trading at a premium valuation. This phenomenon occurs because investors are willing to pay an extra premium for companies that exhibit qualities such as quality, sustainability, and a track record of consistent earnings’ performance. 

Unveiling the PE Ratio-Return relationship: Insights from our research 

The correlation between a company's Price-to-Earnings (PE) ratio and its one-year forward return is evident in this table and chart. For stocks with a PE ratio below 10, there's an impressive one-year forward return of 51.69 per cent, indicating substantial potential for capital appreciation. Companies in the 15-20 PE ratio range offer a respectable one-year forward return of 18.51 per cent, reflecting a balanced risk-return profile. In the 20-25 PE ratio band, returns are positive at 7.62 per cent, though they taper off as the PE ratio climbs. Finally, for companies with PE ratios exceeding 25, the one-year forward return is 6.97 per cent, suggesting that investors paying a premium for high PE stocks may experience relatively lower short-term returns. Based on our research findings, it becomes apparent that there exists an inverse correlation between the PE ratio and returns. Nevertheless, it's important to highlight that this correlation may not consistently apply to every individual stock, as certain exceptions and variations may exist.

Understanding PEG Ratio

Peter Lynch, the former manager of Fidelity Funds, frequently sought out growth-oriented companies that capitalised on prevailing market trends. In many cases, these stocks appeared to have high valuations when assessed through conventional metrics like the price-to-earnings ratio. However, in hindsight, they proved to be attractively priced considering their potential for growth. “The PE ratio of any company that’s fairly priced will equal its growth rate,” he said. To enhance the analysis of growth-oriented companies, Lynch employed the PEG ratio, which is calculated by dividing the price-to-earnings ratio by the company’s growth rate. 

This criterion was among Lynch’s preferred methods for evaluating stocks. Here’s how it operates: Let’s consider a comparison between two different stocks, both of which have a price-to-earnings ratio of 25. On the surface, they may seem similar, but let’s examine their respective growth rates. Suppose Company A is experiencing earnings’ growth at a robust rate of 30 per cent while Company B’s earnings are growing more modestly at 10 per cent. In this scenario, Company A would have a PEG (price-to-earnings to growth rate) of 0.83 (25 divided by 30 equals 0.83), while Company B would have a PEG of 2.50 (25 divided by 10 equals 2.50). 

A lower PEG ratio indicates a more appealing valuation relative to a company’s growth prospects. As per Lynch’s investment philosophy, a PEG ratio of 1 or less was deemed highly favourable. Lynch took an additional step when evaluating companies that paid dividends and were categorised as slow growers. He recognised that dividend yields played a significant role in the overall return of slower growing firms. In such instances, Lynch adjusted the PEG ratio by incorporating the dividend yield into the growth rate within the denominator, resulting in a yield-adjusted PEG ratio. 

Disadvantages of PE

One inherent challenge posed by relying solely on the PE ratio is the underlying assumption that a company’s future earnings will, at the very least, match its current earnings. In the context of a company trading at a PE ratio of 10, investors essentially wager that the company will sustain its present earnings’ level for the next decade! As someone immersed in the world of investing, it becomes evident that forecasting a company’s earnings even a year or two ahead is a complex task, given the dynamic nature of the markets and business environments. Attempting to project earnings for an extended period of 10 years into the future is an even more formidable challenge. 

Another inherent limitation lies in the notion that a stock trading at 10 times earnings is inherently cheaper than one trading at 15 times earnings. This conventional belief is grounded in the assumption that a company will maintain its current earnings level for the subsequent 10 years, allowing investors to recoup their initial investment. However, in reality, this assumption is largely theoretical. The reality is that a company’s earnings’ trajectory over the next decade can vary significantly. Earnings may experience substantial growth or decline during this timeframe. 

Naturally, investors are inclined to favour companies poised for substantial earnings’ growth rather than those potentially facing significant declines. Unfortunately, the PE ratio, as a standalone metric, lacks the capacity to predict these future earnings’ movements. Notably, it provides no insight into the health of a company’s balance-sheet. There might be instances where a company with a seemingly low PE ratio of just 2 times earnings is, in fact, exorbitantly expensive due to an underlying issue – a substantial amount of current debt that it lacks the means to service. Consequently, this scenario could lead to the company facing bankruptcy in the current financial year. 

It’s not uncommon to hear discussions comparing two companies – one trading at a PE of 8 times earnings and another at 16 times earnings – with a conclusion that the former is the cheaper option. However, a deeper examination often reveals a more nuanced picture. Upon closer scrutiny, we might find that the company trading at 8 times earnings recently enjoyed a one-time windfall profit unlikely to recur. In contrast, the company trading at 16 times earnings has demonstrated consistent annual earnings’ growth of 20 per cent over the past 15 years. In this light, it becomes apparent that, factoring in these critical aspects, the company with the higher PE ratio may, in fact, represent the superior investment choice.
 

Conclusion

A company’s intrinsic value is determined by its capacity to increase cash flows, not just earnings. Unfortunately, the stock market, often incorrectly, places a significant emphasis on earnings and PE multiples, diverting attention from the primary factor responsible for compounding wealth. For instance, consider the case of Astral Poly between the years 2010 and 2020, where its profits surged by a factor of 9 (a remarkable 24 per cent annual growth rate), and its stock price multiplied by a staggering 60 times. Consequently, many investors labelled Astral Poly as a ‘high PE’ stock during this period. However, when examining the same decade (2012- 2022), Astral Poly’s free cash flows expanded by over 50 times. 

Investors who focused on Astral Poly’s cash flows rather than its earnings reaped the rewards of more than a 50-fold compounding effect within this dominant CPVC manufacturing franchise. According to legendary investor Warren Buffet, “Common yardsticks such as dividend yield, the ratio of price to earnings or to book value and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business.” The PE ratio on its own lacks the depth necessary for informed decision-making. Buffett has acknowledged that relying solely on the PE ratio and book value can be overly simplistic when calculating the true intrinsic value of a stock. 

Particularly, when he has the ability to compute an actual intrinsic value for a share, the PE ratio and book value may seem rudimentary in comparison. Using the PE ratio as the sole measure is akin to attempting to estimate a person’s weight by merely observing their shadow. Such an approach would only yield accurate results if one also considered factors like the angle of the sun and made assumptions about the person’s body composition, which may not be discernible from the shadow alone. It’s entirely reasonable to anticipate that investors will prioritise stocks with clear earnings’ growth prospects over alternatives. 

In an economic cycle that has yet to demonstrate a sustained upward trend, this preference can lead to a situation where a greater pool of capital is pursuing a limited selection of stocks. 

Consequently, under such circumstances, the PE ratio in certain cases might appear inflated or overstated. Investment opportunities in the stock market are ever-present. There are moments when the market offers a plethora of choices, while at other times you must exercise caution and carefully select from a narrower range of options. Currently, the market’s PE ratio might appear elevated when viewed in isolation. However, when considering other critical parameters like the earnings’ cycle, price-to-book value, market capitalisation to gross domestic product (GDP) ratio, and more, the landscape differs from the previous market peaks. 

The decision to buy or abstain from buying hinges less on the overall market valuation and more on the quality of earnings specific to an individual stock. For long-term investors, it is advisable to disregard short-term fluctuations in the PE ratio, which are often influenced by market noise and liquidity factors. Instead, focus on the enduring characteristics of a stock’s earnings’ potential to make informed investment choices. While the PE ratio remains a valuable tool for evaluating stocks, investors should utilise it in conjunction with other valuation methods. It should never serve as the sole basis for making investment decisions. 

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