Lesson 8 – Price to earnings ratio, Price to book ratio

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Lesson 8 – Price to earnings ratio, Price to book ratio

In this lesson, I will discuss price to earnings ratios (P/E) and price to book ratios (P/B), how they are calculated and how they can be used in stock analysis.

 

What is a price to earnings ratio?

P/E ratios are popularly used to understand whether a stock looks overvalued or undervalued. You would have encountered them in business newspapers or the financial news channels.

There are two ways to calculate this ratio.

P/E ratio = Market capitalization / Profit after tax

Or

P/E ratio = Price of share / Earning per share

If you have understood the earlier lessons properly you will accept why both these methods will give you the same answer. If you have doubts, I recommend re-reading Lesson 5 and Lesson 6.

 

What is the right P/E ratio?

Doctors and patients have it far easier than a stock investor. One can easily refer a chart that tells you whether blood sugar levels are low or high.

P/E does not behave as scientifically. “High” and “low” P/E are relative terms.

These guidelines will help you,

  • Compare the P/E of a stock that you are studying with other companies in the same industry sector. Typically they tend to stay in a similar range.
  • If the P/E of a stock is high as compared to its peers, there need to be good reasons. They may include superior earnings growth potential, good management and better return on equity ratios.
  • Within the same sector, depending on size of companies, P/E ratios may differ. Usually smaller companies have a lesser P/E ratio.
  • Look at a company’s historical P/E ratio. See how today’s P/E ratio compares against the P/E range it has traded in the past.

Historical P/E ratio comparison is a very useful technique which I follow. Unless something has changed permanently for the positive, P/E ratios which have shot up too high usually can be expected to revert to average levels seen in past 5-7 years.

Vice versa, if P/E ratio has come down below long-term averages and if the business outlook is good relatively, it might be a buying opportunity.

I have explained how to find historical P/E ratios in this video.

Is a high P/E ratio bad?

Remember that high P/E ratio is not always a bad thing.

A good company that is featured in the benchmark indices like Nifty or Sensex might have a high P/E of 25-30 times earnings that continues to stay in that range for many years. That is because the quality of earnings might be good. Growth might be steady and dependable.

One word of caution in very high P/E stocks is that it takes a bad quarter of results or adverse announcements for stocks to come tumbling down.

Sometimes, high P/E ratio stocks tumble down simply because gravity catches up with them. They have simply run up too high in terms of valuation and there is no more buying demand at those prices.

This is a common danger in “themes”. Dot-com, real estate, infrastructure, FMCG stocks have been bid up to high valuations in 1999-2000, 2005-2007 and 2012-13 respectively.  We know how the dot-com, real estate, infrastructure sector stocks crashed subsequently. What happens with FMCG stocks remains to be seen.

I urge you to read the article on Infosys to understand the dangers of super-high P/E investing, that I have shared at the end of this lesson.

 

Should you buy only low P/E stocks?

Stock price can be expressed as follows,

Stock price = Earnings * P/E

In a high P/E stock, you might not have the P/E ratio increase further but you might have earnings increase.

You stand to make more money comparatively in a low P/E stock if its earnings increase and the P/E ratio increases over time.

A word of caution is mandatory. All low P/E stocks are not necessarily cheap in terms of valuation. As in real life, things might be cheap because they are not of good quality.

I have discussed qualitative stock study in earlier lessons. If the business is qualitatively good, good financial parameters stay steady  or improve, and P/E ratio is low, the stock can be a good investment.

 

What is a index P/E? Why should you use it?

The broader indices also have a P/E ratio that can be found on the exchange websites.  I have shared an article at the end of this lesson that takes you through this philosophy of looking at index valuations to understand whether a market looks overheated or undervalued.  This is a very useful check to do in addition to individual stock analysis.

What do you mean by book?

Book refers to book value of a company. We discussed net worth in Lesson 5 – Understanding Financial Statements

For practical purposes,

Book Value = Net Worth = Equity capital + Reserves & Surplus

Strictly speaking,

Book Value = Total Assets – Total External Liabilities

What is listed in the financial statements is as per accounting records.  For example, Plant & Machinery that is listed at a cost of Rs. 5 million will typically not fetch this amount if sold on the market.  It will go at a discount.

Thus, the total assets term will usually be lower than what is given in the balance sheet.

Total External Liabilities involves all that the company owes to banks and financial institutions. It also might include dues to government agencies like income tax liabilities and excise dues.

You will agree that liabilities usually are what they are. They typically will not come down like assets.

For a company where business is not in distress or close to bankruptcy (a “going concern” in accounting terms) you may take the net worth figure and not go into elaborate calculations that the second formula would require.

So, now you have the book value.

 

What is a price to book ratio?

P/B = Market capitalization / Book value

Or

P/B = Share price / Book value per share

Companies with a low P/B hovering around 1 are considered to be cheaply valued. But like I talked for P/E ratios, be sure that the stock is cheaply valued and there is no obvious reason for it being cheap.

You should follow similar comparisons to sector and past P/B valuation range as in the case of P/E ratios.

 

Linking this to margin of safety

You have studied margin of safety in Lesson 7. There will be margin of safety in the investment if all things are fine and the stock is trading at the lower end of its valuation range in terms of P/E and P/B for the last 5-7 years. If you want to be extra safe, some recommend looking at a 10 year period.

These valuation ratios should never be seen in isolation. You cannot avoid the qualitative study of the business that lies behind the stock.

 

Homework

Go to this link for Hindustan Unilever. See its P/E ratio and how it stacks up against peers. Click on More in the P/E table area and see financial details of the compared companies in the FMCG sector.

Like this try exploring P/E ratios and P/B ratios for different sectors like IT (Infosys), power (NTPC).

 

Recommended Reading

How Infosys left many underwater for more than 6 years

Large cap, mid cap, small cap valuations – how are they placed?

 

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