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The dynamics of earnings multiple

Utpal Choudhury

The first step towards turning into a smart investor is to get your stock valuations right. There's unanimous agreement on the fact that when an investor makes an attempt to determine the worth of a stock based on "fundamentals", he is on his way to making a better-informed decision.

In fact, if investors fail to understand what makes a stock price tick upwards, it becomes all too easy to get lost in the sea of quirky short-term market movements. This is particularly true when you need to take a long-term investment decision.

With basic skills in math and some diligence, anyone can calculate the fundamental values of a stock using simple and well-known valuation models. This time, we discuss two widely used earnings- based valuation tools - the price-earnings ratio and earnings per share.

A popular P/E

You can deduce the EPS of a stock by dividing the net profit of a company by the number of outstanding shares. For example, suppose HLL has Rs 2.20 billion of outstanding shares and earned a net profit of Rs 16.40 billion during the year.

The company's EPS will be Rs 7.50 (Rs 16.40 billion/2.20 billion). The EPS alone, however, doesn't say much. To draw more meaningful conclusions, most investors reach out to a tool called the P/E ratio.

The P/E ratio is the market price per share divided by the EPS. In our instance, assume HLL currently trades at Rs 198 per share. If the EPS is Rs 7.50, the P/E will be 26 (Rs 198/Rs 7.50).

However, judging by the number of investors who swear by the strategy of picking stocks based on low P/E ratios, it does seem that this ratio has been highly over-simplified - or poorly interpreted.

Many investors just dive into a stock, based on the fact that its P/E value is low. But are low P/E stocks really a bargain deal? To find the answer to that question, we need to delve a little deeper into the concept of P/E.

P/E is simply the price the investor pays while buying a share, for each rupee of company earnings. For instance, Infosys has a P/E of 27. That means the investor is buying each rupee of Infosys' earnings at Rs 27.

Similarly at its current price, each rupee of earnings of Kodak India is trading at Rs 12. Why does the price you pay for earnings of one company differ from that of another? There are two reasons: one factual and the other, notional.

The factual reason:

"Company P/E ratios, computed as they are from the most recent earnings per share, can take on almost any value, including, for example, infinity in the case of a company whose earnings have only temporarily dipped to a negligible amount," writes L C Gupta in a book co-authored by him called "Indian Stock Market P/E Ratios".

This is particularly true in the case of cyclical stocks like shipping, cement and metals.

There is no straight way to get rid of this problem. "You need to look at the whole situation and use a lot of judgment," writes Gupta. So, before jumping to any conclusions, it's important to examine whether the EPS is following a normal path.

The notional reason:

Despite the problem mentioned earlier, P/E multiples are hugely popular with the analyst community, chiefly because of its notional reason.

Let us consider two companies: G Ltd and F Ltd. Each has an EPS of Re 1. The EPS of G is expected to grow 50 per cent in the next year, while that of F is expected to rise 20 per cent. Which stock would you prefer to buy? Clearly, G's shares. Obviously, the price of G will be higher and so will the P/E.

If both stocks are priced similarly, at Rs 10, then the P/E multiple of each stock will be 10. A year on, if the P/E doesn't change, the price of G will be Rs 15, while that of F will be Rs 12. Clearly the returns that F's and G's shareholders will enjoy after a year will be different.

It should, then, hardly come as a surprise that the P/E ratios will not remain the same (Don't ask me what the P/E of F and G will be after a year. If I knew that, I would have been a very rich person!)

If you can figure out the expected growth rate, it is possible for you to estimate what the price should be at different P/E multiples. The obvious risk: you can go wrong in projecting the company's growth rate, turning your projections of P/E multiples and stock prices awry.

Take a look at Chart 1. It lists the price for Nestle's stock at different P/E multiples till 2009. The current price of the company is Rs 500 and P/E is 20. The assumption here is that the bottomline will continue to grow at 30 per cent.

It all boils down to PEG

To further simplify the relationship between the P/E and growth rate of EPS, analysts frequently use the P/E to growth ratio. This measure simply considers the annualised projected growth rate of EPS and compares it with the stock's current P/E multiple.

If a company is expected to grow by 20 per cent a year and its current P/E ratio is 10, the PEG will be 0.50 (P/E of 10/growth rate of 20 per cent). A rule of thumb is that any stock with a PEG of 1 is fairly valued.

In our example, the stock with at PEG of 0.50 is trading at half its fair value and can be considered a good buy. A stock with a PEG above one is "overvalued" and should be sold.

So, we now come back to the original question: is a low P/E stock really a good bargain? Not always. It depends primarily on the projected growth rate for the company and other factors such as sustainability of that growth, transparency levels and the value of its assets.

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