The price-to-earnings ratio is one of the topmost tools for stock valuation. But one cannot measure the growth potential of a company only on the basis of P/E. Before diving in to check if P/E a good measures of stock valuation, let’s understand what this ratio exactly is.
The price-to-earnings ratio measures the current share price relative to its earnings per share (EPS). This meaning, thereby, that the P/E ratio shows how much the market is willing to pay for each rupee earned by the company.
Valuation of a stock is usually analysed through multiples such as price-to-earnings ratio (P/E ratio), earnings per share (EPS), price to book value (P/BV), price to sales (P/S), EV/Ebitda (enterprise value/earnings before interest, tax, depreciation and amortisation), etc. in a certain order.
The P/E ratio is the most commonly used one; it is also one of the most useful, as it helps narrow down the universe of possible investable choices. Actually, the P/E ratio is used to determine relative value of a company’s shares in an apple-to-apple comparison i.e within the same industry. The lower the ratio, the more attractive the stock is, as long as the stock has the growth potential.
A high P/E ratio could mean that a company’s stock is over-valued, or else investors are expecting high growth rates in the future.
The problem is, the P/E ratio overlooks assets and liabilities, which usually have a material impact on valuation. That means the price-to-earnings ratio is useful, but only to a point.
In the current scenario for instance, there is a disruption in businesses due to Covid-19 and earnings of many companies have come down sharply, but their P/E ratios remain high. Here one needs to understand that the market is forward looking, and is pricing in future earnings. In some cases, the P/E ratios may have corrected substantially. Thus, relying on this ratio alone may not lead to right decisions in the current scenario.
The reason behind this is that if one using purely trailing P/E, the denominator reflecting earnings growth of trailing 12 months may no longer reflect the earnings reality amid the ongoing economic shocks. Thus, the P/E will seem optically low, as share prices have corrected sharply relative to the trailing earnings profile.
Stock valuations are not static, but dynamic. Depending on broader factors, such as market sentiment and sectoral preferences, they keep changing with time.
The P/E ratio is indeed a useful starting point. But it is not the end of an analysis of a company. Unfortunately, there is no single tool for all industries and stocks.
One ratio cannot be applied blindly to value stocks across sectors. As with so many things in financial markets, it is difficult to apply a thumb rule. A high growth, low capital-intensive company must be valued on P/E, whereas the P/BV or the replacement value is considered a more appropriate tool to value capital-intensive businesses.
While cement manufacturers are best valued using EV/Ebitda, real estate firms are best analysed using NAV. A good way of understanding a company’s valuation is to look at it in the context of the sector in which it operates. One needs to have a fair understanding of the nature of business and sectoral growth prospects to arrive at an appropriate tool to value a business.
DK Aggarwal is Chairman and MD, SMC Investments and Advisors.