PE Ratio: What It Does Not Tell You

Stock market analysis with the help of PE multiple is extremely popular. There could be very many reasons for PE being a favoured ratio for stock market analysis but it may not be the most appropriate way to look at PE and take investment decisions. Yogesh Supekar highlights the importance of looking beyond the PE ratio while discussing the risks of giving too much emphasis to it  [EasyDNNnews:PaidContentStart]

Price to earnings (PE) ratio is the first thing one learns when it comes to the stock market. Most stock market books, almost all the stock market courses and majority of curriculum related to stock market emphasise on understanding the PE ratio and attempt to simplify reading the complex stock market with a simple PE ratio. On the ground too, the use of PE ratio amongst investors is commonplace. Market commentators use PE readings to narrate market conditions almost on a daily basis and that is partly the reason why investors tend to give so much importance to the PE multiple. It is the combination of being intuitively appealing and the huge acceptance of PE ratio along with the simplicity of calculation that makes it such an attractive matrix to read market valuations and thereby gauge the mood of the market. 

Defining the PE Ratio

The PE ratio simply tells us a lot about the market’s current view on companies’ earnings. Simply put, the PE ratio compares a company’s stock price with its earnings per share and helps determine if it is fairly priced. Higher PE ratio often leads investors to conclude that a stock could be overvalued and a lower PE leads investors to believe that the stock is undervalued. However, it may not always be true. What do PE ratios don’t tell you? PE ratio helps us understand if a particular stock is fairly valued. There are various ways to estimate from the current PE if the stock is fairly valued. One of the most popular ways is to estimate if the current PE is trading higher than its long-term average. 

One can safely suggest that if the current PE is way higher than the long-term average, the stock could be overvalued and vice-versa. One must remain cautious during times when the PE is wandering way above the long-term average PE multiple. However, it may not always be useful to look at PE and decide the market direction. For example, in September 2020, the Nifty PE ratio was 33.26, which was way higher than 25 that is considered as a level above which the market can be claimed to be overvalued. Since September 2020 when the NIFTY PE was at the 33 levels, the key benchmark index gained 57 per cent to make all-time highs and even after a decent correction, Nifty has been higher by 37 per cent from the levels of September 2020. 

This goes to show that the PE levels rarely show you the future direction of the markets. Imagine an investor looking at Nifty PE level in September 2020 and ignoring the markets just because the PE was more than 33. Similarly, the current PE for Nifty is a little less than 20, as per data published on the National Stock Exchange (NSE) website. It does not suggest in any way that with this PE the markets may not head lower. The PE levels have close to zero predictive value. That said, as a thumb rule whenever Nifty PE has come closer to the 12-15 range, it is considered extremely attractive for long-term investments and if Nifty PE hovers above the 28-30 levels, it can be considered overvalued. 

Apart from the fact that PE ratio has little predictive ability, which is extremely essential to beat the markets, PE ratio carries most of the flaws that emerge from the way earnings are recognised. In other words, if the earnings have been manipulated, the PE ratio will reflect a wrong multiple all together and the investor who has complete faith in the most monitored ratio i.e. the PE will be making erroneous readings about the market moods based on manipulated figures. Investors must be cautious of such manipulative practices adopted by corporate organisations. We all know what happened with Satyam Computers. Investors tracking the PE ratio of Satyam Computers at the time when the earnings were fudged in the first place were totally misguided by the ratio. 

"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 that they provide clues to the amount and timing of cash flows into and from the business. "
- Warren Buffet 

All about the PEG Ratio 

The PEG ratio is a company’s price/earnings ratio divided by its earnings growth rate over a period of time. PEG ratio adjusts the traditional P/E ratio by taking into account the growth rate in earnings per share that are expected in the future and it is thought to provide a more complete picture than the more standard P/E ratio. 

Read the Fine Print
Investors have to be wary of those companies that engage in serial acquisitions which can easily boost profits. The PE ratio in such cases can be consistently inflated. At times certain companies with corporate governance issues can manipulate the revenue figures as well. Inflated revenues can lead to inflated profits which inflate the EPS figures, which in turn lead to incorrect PE reading. Occasionally, companies tend to recognise the revenue early and end up inflating net profits while also deferring the expenses. Investors ought to understand that listed companies may resort to adopting creative accounting policies for depreciation and revenue recognition which may in turn lead to PE being higher than it should be. These factors make it very difficult to trust the PE figures. 

Also, with interest rates being at historical low levels, the earnings have had a booster dose given by the central banks of the world. However, with interest rates now expected to normalise, the PE suddenly looks like data that cannot be relied upon. Apart from the creative accounting practices that can lead to inflated PE ratios, one of the reasons for unsustainable PE multiple is boost in earnings due to one-time gains realised by a listed company. This could be through the sale of any asset or a strategic one-time sale leading to huge one-time cash flow. Such non-operating cash flow can lead to artificially high PE ratios. Practically, when a company is loss-making it will never reflect a PE multiple. 

All about the PEG Ratio

The PEG ratio is a company’s price/earnings ratio divided by its earnings growth rate over a period of time. PEG ratio adjusts the traditional P/E ratio by taking into account the growth rate in earnings per share that are expected in the future and it is thought to provide a more complete picture than the more standard P/E ratio.

How to calculate the PEG Ratio?

PEG Ratio =

Price / EPS
——————
EPS Growth

Where, EPS = Earnings Per share

To calculate the PEG ratio, an investor or analyst needs to calculate the P/E ratio of the company. The P/E ratio is calculated as the price per share of the company divided by the earnings per share (EPS), or price per share/EPS. After the calculation of PE, factor the expected growth rate into the above equation.

A low P/E ratio may indicate that the stock is a good bet to buy but factoring in the company's growth rate to get the stock's PEG ratio may tell a different story. The stock can be identified as more undervalued if the PEG ratio is lower given its future earnings expectations. Adding the company's expected growth into the ratio helps to adjust the result for companies that may have a high growth rate and a high P/E ratio.

In the words of Peter Lynch, the famous financial and value investor - A PEG ratio of 1 portrays equilibrium. The equilibrium is between the recognized value of a stock's worth and its earning potential.

The degree to which a result of the PEG ratio indicates an overpricing or underpricing stock varies according to industry and by company type. On an overall basis, investors are more inclined toward a PEG ratio that results below one. 

Any investor who focuses on the PE levels to decide the attractiveness of an investment will tend to ignore all the loss-making companies owing to lack of PE multiple to scan the investing opportunity. Ironically, it is not strange to see the stock prices of struggling or loss-making companies multiply as a turnaround story gets into motion. A pure focus on PE will make spotting such lucrative turnaround tales almost impossible. Consider, for example, what happened with CG Power. Its shares jumped from Rs 5 per share to almost Rs 220 per share within 18 months of its turnaround. However, those investors who were focused on PE for valuation and investing opportunity would have missed this chance by a huge margin. 

Here is list of quality stocks where the TTM (Trailing Twelve Month) PE is less than the industry average PE. 

The PE ratio would not have helped in this case. This goes to show that PE ratio cannot help you in spotting turnaround opportunities when the company is making losses and expected to become profitable. Also, even though PE ratio is popular because the common perception is that it is easy to understand, calculate and compares between stocks, in reality things are much more complicated, and it is almost futile to compare two stocks from different industries. Very few investors actually take efforts to compare the stock PE with the industry average PE. Instead, most investors make the cardinal mistake of comparing stocks from different industries with the help of PE. While forward PE is more useful than the trailing PE, there is no way investors can calculate for themselves the forward PE. Investors have to rely on brokerage research reports to get the forward PE figures. But very few investors understand how to use the forward PE multiple in an investment strategy. 

“In the initial phase of my investment journey I would never ignore the PE but after spending a couple of decades in the markets I have realised that PE values are not needed if my focus is to estimate the intrinsic value as the main gauge of the value of a stock or the markets for that matter. I have also realised that the PE levels at which I can say a stock is a good bargain can vary over a huge range depending on circumstances. The market is too complicated to be simplified by a single ratio i.e. the PE. To scan investment opportunities the key is to identify stocks with earnings explosion, quality management and positive industrial trends. PE does not help you in identifying any of these. However, it can be a part of your market tools,” says Rahul Gaikwad, a seasoned investor. 

Trailing PE vs Forward PE vs Shiller PE

The price-to-earnings ratio is one of the most popular valuation metrics used by investors and analysts to determine the relative value of a company's shares. It is useful in making investment decisions. A company’s PE ratio can be compared against its historical record or the industry PE. The ratio indicates whether a stock is overvalued or undervalued at its current price. A high PE ratio suggests that the stock is overvalued, or that investors expect high growth rates in the future. The beauty of the PE ratio is that it standardizes stocks of different prices and earnings levels, permitting for an apples-to-apples comparison. 

There are several different types of PE ratios used in practice. PE ratio may be estimated on a trailing (backward-looking), forward (projected) or average basis. Trailing Twelve Months (TTM) PE is calculated as the current share price divided by the earnings over the past 12 months ie last 4 quarterly EPS. TTM PE is more optimal relative to an individual’s earnings estimates. TTM PE also furnishes an insight into whether the overall market or index is too high or low in comparison to past PE ratios. However, a key limitation of the trailing PE ratio is that it doesn’t take into account a company’s future earning potential. 

TTM PE is dynamic as the price of a company’s stock changes every trading day while earnings are only declared each quarter. Thenceforward PE ratio is also considered by investors. Forward PE is calculated as the current share price divided by estimated future earnings based on the guidance received from company management or analysts. Forward PE evinces a distinct idea of a company’s future earnings which is more relevant than trailing PE because past earnings tend to be discounted in the current share price. A drawback of forward PE is that it is easily prone to deliberate misestimation either by the company’s management or analysts. If a company’s forward PE ratio is lower than the trailing PE ratio, then analysts expect earnings to increase and vice-versa. 

Another popular variety is the Shiller PE ratio. It was popularized by eminent Yale University Professor Robert Shiller. The ratio employs average earnings per share (EPS) over the last 10 years, adjusted for inflation. This helps eliminate the variations in earnings that transpire over different stages of a business cycle (such as expansion or recession) while taking into account the company’s long-term financial performance. Therefore, the ratio is commonly referred to as the cyclically adjusted price-to-earnings ratio i.e. CAPE ratio. Nonetheless, similar to TTM PE, the Shiller PE ratio is backward looking and ignores a company’s future earning potential. 

Caught on the Wrong Foot 

In the last 20 years, for example, the S and P 500 has seen PE ratios as low as 13 and as high as 123. While that high number of 123 might make it seem like the market is extremely valued, that ratio happened in the spring of 2009 — the beginning of one of the longest bull runs in the US’ history — and so an investor who sold based on the high PE ratio would have missed out on all those gains. 

Conclusion

While the PE ratio is great to understand how much price the market is willing to pay for earnings per share generated by the company, it can be extremely adventurous to base one’s investment decision looking at the PE ratio alone. Fair value cannot be estimated by looking at PE alone. The way the human mind works, we always hunt for objective answers. In pursuit of making investment management easy and profitable, often investors want to identify classic investment opportunities based on PE levels. Practically, this rarely works. 

Several myths regarding PE levels impact investors’ decisions and can mislead the investing public, forcing them to unprofitable outcomes. Low PE is always good or stocks with high PE ratio outperform in the short run are some of the unfortunate myths that influence gullible investors who want to view the stock market in an objective manner. Some of the investors think that any stock with a PE lower than 10 is attractive and a PE greater than 50 is overvalued. There is no single PE level that explains the attractiveness of a stock and yet there are efforts made to understand that magic PE level by several investors. 

In short, there is no empirical data that supports the argument of low PE stocks consistently outperforming the high PE stocks and vice-versa. Indeed, the market is such a place where the PE of 10 can be expensive for a stock while a PE of 70 can be cheap for a particular stock. Successful investors use the PE ratio in tandem with expected growth in earnings, changes in business strategy and environment, market opportunity and the ability of the company to tap the ever-growing opportunities to identify the winners. Relying on PE level alone is a sure-shot recipe to burn capital both in the medium and long run.

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