One of the basic tenets of investing is to ‘buy low and sell high’. In other words, profits can be maximised by buying undervalued stocks and selling them when they are overvalued. This is how fund managers of a mutual fund scheme decide whether they are paying a fair price for their investment.
In equity markets, the Price to Earnings ratio (PE Ratio) is one of the widely used parameters for identifying the valuation of an investment. The PE Ratio is the price investors are willing to pay for every rupee of a company’s earnings.
The formula for calculating the PE ratio is as under:
PE ratio = Market price per share/Earnings per share
The Earnings per share (EPS) is the Net profit of the company divided by the number of shares.
So, if a stock is trading at a PE multiple of 10x, it means that it is trading at 10 times its annual earnings. A high PE ratio means that a stock is expensive (overvalued), whereas a low PE ratio means that a stock is cheap (undervalued) compared to its fair value.
Is a high PE or low PE better?
A high PE Ratio generally means that investors have high expectations of strong future earnings growth of a particular business and are, therefore, willing to pay more to buy stocks of such companies.
Generally, growth-oriented stocks have a higher PE Ratio as these companies are expected to grow their sales and earnings at a rate faster than the market. If these companies continue to grow rapidly, it will drive their share price up, and thus, justify their expensive valuation.
However, if the company fails to meet the expectation of earnings growth or if there are high uncertainties about its future, the downside risk on such stocks can be high. In such a case the company is considered to be overvalued.
On the other hand, a low PE Ratio means that the stock is trading lower than its fair value. They are also known as value stocks. It is important to determine whether the low PE is due to short-term factors that will not have any impact on the long-term growth prospects. If the fundamentals of a company are strong, the stock prices of such companies can rise significantly in the future.
Thus, PE Ratio is an important parameter that helps you make investment decisions.
How to use the PE Ratio for comparing valuation?
1) Comparison with peers
The earnings of a company may have grown, but it is important to assess how its peers have performed during the same period. The PE Ratio should be ideally used to compare companies within the same industry/sector as they will have similar business models and will be exposed to the same socio-economic factors.
However, it is important to note that the PE Ratio of large, well-established companies is generally higher compared to smaller, emerging companies within the same sector.
Comparing the PE Ratio of stocks in different industries is not a prudent approach, as every industry has different factors that affect its growth. What is considered a high PE in one industry may be too low for a company in another industry/sector.
2) Comparison with the historical record
Calculating PE Ratio based on past earnings data, usually past four quarters, is the most popularly used metric since actual numbers are available for calculation. Historical values are especially useful for comparing the PE Ratio of companies that have long-term price track records.
The historical PE, or Trail PE, helps you to analyse whether the current PE is trading near the historical highs or lows. If the stock is trading near the lower end of the historical range, then it may indicate an attractive buying opportunity, and vice versa.
3) Comparison of future earnings
Since investors commit money to benefit from the future growth potential of a company, some prefer to calculate the PE Ratio by using future earnings estimates. This is known as the Forward PE. Forward PE is used because past performance is not an indicator of future earnings.
Furthermore, since past earnings remain constant, but the stock price fluctuates daily, investors prefer the Forward PE based on forecasted earnings. However, it is crucial to note that there could be a lot of uncertainties in the future, and the company may or may not meet its earnings target, looking at the Forward PE may result in an incorrect judgement. Also, the company can change its estimates which could make the Forward PE obsolete. This is why some analysts prefer to use both, Forward PE and Trail PE to arrive at a trustworthy figure.
In conclusion…
As we have seen, the PE Ratio is an important tool to determine whether a stock is undervalued or overvalued. It can also be used to value indices such as S&P BSE 500 or NIFTY 50.
Before making an investment decision remember that a high PE Ratio is not always a warning sign that it is overvalued and the prices may fall in the future. The high PE could be because investors are expecting better future earnings growth, and thus they are willing to pay more per earnings of share.
Similarly, a low PE ratio does not always indicate value buying opportunities. A stock could have a low PE because investors are pessimistic about the future earnings of the company, or because of poor governance, or other such factors.
Notably, during a booming market, stock prices can rise well above the fair value due to positive investor sentiments.
Similarly, during a falling market, stock prices fall below their fair value and value managers use the opportunity of adding quality names trading at a discount to its intrinsic value.
This is why adding a value fund within your equity portfolio could help reduce the impact of market downside on your portfolio. A Value fund gives you exposure to quality companies at a reasonable valuation. Due to the margin of safety it offers, value funds act as a good portfolio diversifier. Investors can consider adding around 15% of their equity portfolio to a value fund.
So, if you are using the PE Ratio as an indicator for your investment, ensure that the mutual fund scheme also assesses parameters such as socio-economic factors that affect a company, the future of the industry/sector in which it operates, prospects of earnings growth, liquidity of the stock, the relative performance of its peers, as well as other important ratios such as operating margin, debt to equity ratio, return on investments, etc.
Analyse these factors along with the PE Ratio to take a more informed decision when it comes to evaluating a mutual fund for your equity portfolio.
Happy Investing!
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