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To PE or not To PE

A look at the P/E ratio

There is a beautiful saying in Hindi 'Ummeed pe Duniya Kayam ' meaning the world is in order (rather not in disarray) because of Hope. A hope that tomorrow will be better than today and day after tomorrow will be better than tomorrow.

When you pay money to buy a stock, you are hopeful. You expect the business to do well and reward you with returns. What is the returns you can expect? The dividends that the management pays and the capital gains/losses depending on how much the market values the stock(simply put the stock price).

When will there be larger returns? When the business is more profitable. As the number of shares of a business is a finite figure, more profits mean more returns per share owned. Returns per share is alse called earnings per share or EPS. You want your company to be able to increase the EPS by at least the same rate of returns you expect from your stock. Because if the EPS doesn't increase by that amount, you may not get the returns (dividend + capital gains) you expect. Or is it so?

Ah, we are entering a territory where the river gets murkier, and there's crocodiles in the water. The logical answer is NO. If the EPS doesn't increase by the same amount as my expected returns, I will have to expect lower returns. But markets, at least in the short to medium turn have had a frequent history of defying logic. While the dividends you receive depend on what the company's management deem fit, the share price appreciation/loss depends on what the market thinks it is. There is a popular relation between share price and earnings per share called as the P/E ratio

P/E ratio = Market Price/Earnings per share

This is a ratio that can be used to compare different stocks! Two stocks having very different stock prices can have almost identical PE ratios as their respective EPS' could be different. So a P/E could be a good way to compare performances of various stocks.

What does a PE ratio of say 40 signify. It means that if a stock price is Rs. 400, the earnings per share is Rs. 10. You have to pay 40 times of what this stock earns annually to own it. Put in other words, at current prices, it will take 40 years to recover your investment for owning that stock. Sounds like madness, doesn't it? So why are some stocks like HUL trading at a PE ratio of 70? And what is the correct PE ratio? This is like a kid asking his parent why the sky is blue. There is no easy answer. One thing is clear, lower the P/E ratio, cheaper the investment and vice versa. But let's try to explore this.

The right PE depends on how the market as a collective unit deems it fit. A stable stock with a PE of 5 is much more 'valuable' that a stock with a PE of 50, but this is no guarantee of performance or growth. One sector of stocks can have a PE of 50 and be considered cheap, and another sector can have a PE of 12 and be considered expensive. The market sentiment drives the price of the stock whereas how the business performs drives its earnings per share. In the long term, these 2 are a happy family. In the short term, they can be 'on a break' from each other. It's typical of market forces to favour the hot sector. The PE of hot sectors can have vectors of Elon Musk's SpaceX. The PE of the out of favour sectors can have the characteristics of Musk's 'Boring Company'.

So what's a good PE?

The answer to this question is - a good PE is whatever you think it is. This is a good answer if you're a long term investor. For a short term investor, a better answer could be - A good PE ratio is whatever the market decides it to be. Ah, these financial advisors, they never give straight answers! Believe us, we would have loved this to be straight forward. But it's not. So lets look at what the market thinks a good PE was over the years.

Below is the long term PE trend of the NIFTY 50 index.

Source: Trendlyne

You will be happy to learn that the NIFTY 50 index is currently trading at it's highest PE ratio of 31.33 which is the in the last 2 decades! If you've been reading this article carefully, you would have already deduced that this growing PE must mean the EPS would be rising, and hence we are in a bull market!

Well, let's take a look.

Below is the long term EPS trend of the NIFTY 50 index.

Source: Trendlyne

The EPS for the NIFTY has grown impressively from 2003 to 2014. Since 2014, not so much. In fact, the EPS right now is the same as what it was in May 2014: around 360 per share. :(

We have a situation! The EPS is flat, but the PE ratio indicates a bull market. This means the stock prices are getting more disjointed from actual business performance.

It is anyone's guess that the massive drop in EPS is owing to the pandemic, but things weren't that great before the pandemic struck either. We had a slowing economy, rising unemployment and a banking crisis. The pandemic hasn't helped the situation. While some businesses have done well as a result of the pandemic , most of them have struggled and are grappling to stay afloat. The net effect is the decline in the EPS of the NIFTY.

A rising PE ratio could indicate that investors believe that the drop in EPS is temporary. This could be on the sentiment that India has a stable government which will eventually lead India to become a global superpower that she is destined to become.

Conversely, it could also mean that the markets are in irrational territory.

This does not mean that ALL stocks are expensive. There are some real steal deals available out there if you know where to look. If you don't know where to look, consider employing us!

A rising PE and a falling EPS is like an elastic band being stretched. One of the 2 ends has to give. Either the PE has to fall, or the EPS has to rise. Because if the elastic band snaps, investors will have a lot of pain in their hands.

Disclaimer: Tequity Investing considers a lot of variables besides PE before deciding on an investment. This was a piece to give a broader perspective on the Indian equity market, and doesn’t imply any recommendation.

Tequity Investing is a SEBI registered investment advisor. - INA000014915

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