Thread by @ValueEducator

#PERatio is the most widely used valuation ratio. But very often, it can be highly misleading and is very often misinterpreted by investors.

In today’s thread, let us understand how to use the ratio and deep dive into the factors influencing it.

#Investing #valuation #stocks

What is PE?

PE ratio is calculated as shown below:

What the P/E simply means is how much are you willing to pay for ₹1 earning of an asset. So using this analogy for stock investing, the lower the PE ratio the cheaper the stock is and vice versa.

Therefore, you should buy a stock at low PE and sell at a high PE according to this interpretation.

However, the PE ratio is not so simple according to this interpretation. There are other factors which are at play which determine the PE value. These factors are:

1)Market perception:
If a stock is expected to grow at a good rate in the future due to the guidance given by the management or the general investor expectations, the market will give a higher PE to that stock
The PE also depends on the competitive intensity within the industry

For e.g. if there are only 2-3 players within an industry, the market will give a high PE to each of them as against an industry which is highly competitive.

If a business has a history of bad corporate governance, the stock will trade at a lower PE as compared to a business with a good corporate governance.

2)Longevity and certainty of cash flows and earnings:

Companies like HUL and Nestle operate in the FMCG industry where the product demand will be more or less stable irrespective of the external factors. The stable demand ensures stable cash flows and earnings over the long term

Due to this reason, HUL trades at around 61 PE and Nestle Ltd trades at around 80 PE.

3)Interest rates:

In a scenario where interest rates are low, there is a high liquidity in the market. The companies can borrow at a lower cost and invest in opportunities which are able to generate returns higher than the borrowing cost.

This will lead to a growth in earnings and subsequently a high PE multiple.
In a scenario where interest rates are high, there is not much liquidity in the market. Companies would face higher borrowing costs which will lead to lower earnings and subsequently a low PE multiple.

How to interpret PE?

1)A case where high PE can be misleading:

In the case of Deepak Nitrite, before they commissioned their Phenol plant in 2018, the stock was trading at a PE of 81x. Post commissioning of their Phenol,

the Net Profit of the company increased from ₹79 crores in FY18 to ₹1434 crores in FY22. This rise in earnings led to a fall in PE from 81x to 11x therefore, the high PE of Deepak Nitrite did not have much meaning in this case.

In the case of Deepak Nitrite, the forward PE would have been a good measure of PE instead of the trailing PE as Deepak Nitrite generated significant earnings post their Phenol plant commissioning in 2018.

2)Cyclical nature of business:
In a cyclical industry, the earnings of the company are dependent on the business cycle. The earnings will be the highest at the top of the cycle and lowest at the bottom of the cycle.

An example of a cyclical industry is the Steel Industry where the industry is dependent on the fluctuations in steel prices.

Let us consider a hypothetical scenario of a cyclical stock which is trading at a price of ₹90 with earnings of ₹30 in Year 1. The PE would be 3 in this case . Suppose due to cyclical downturn,

the company’s earnings drop to ₹2 with a subsequent drop in price to ₹50 in the next 2 years, the PE in this case would be 25. Therefore, in 2 years though the PE has risen, the earnings of the company have dropped, therefore the high PE of 25 is misleading in this case.

Let us take the example of TCS and Tata Steel Ltd to understand how the market gives different valuations to companies within the same parent group.

In the period of 2015-2022, TCS has consistently posted profits higher than Tata Steel.

except 2022 where Tata Steel has posted profits better than TCS. The steel prices were at their highest in 2022 and due to that, Tata Steel posted better profits than TCS.

The profits of Tata Steel are highly dependent on the fluctuations in steel prices which is not the case with TCS hence, TCS is able to have better profits as compared to Tata Steel.

If we compare these stocks in FY22, we can see that though Tata Steel has posted better profits than TCS, it trades at a lower PE as compared to TCS.

TCS gets a better PE as compared to Tata Steel as the market perceives the earnings of TCS to be stable as compared to Tata Steel whose earnings are highly cyclical. Thus, 2 companies within the same parent group trade at different valuations due to the nature of their earnings

To sum up, Cyclical stocks post their best profitability as a result of which they have a low PE multiple and when they post their worst profitability, they trade at a high PE. This point should always be kept in mind while interpreting the PE of such stocks.

3)Stocks with a low liquidity:

Stocks with a low liquidity are characterized by those with a low float. What this means is that a very small percentage of shares are available for trading in the open market.

An example of a low liquidity stock is Tatva Chintan Pharma Chem Ltd as shown below:

As you can see, the shareholding with the public which was almost 10% in Q2FY22 has reduced over the period of time to around 5.58% in Q3FY23. The remaining shareholding is with the promoters and institutional investors.

In the case of companies like Tatva Chintan, even if the company does not post good results for a few quarters, there is not a significant dip in the stock price as the promoters or institutional investors or the public can maintain the share price by stock buying.

In the period between Q1FY22 and Q3FY22, the company almost had a flat profile for revenues and net profits therefore there was not much growth during this period. However, there was not a significant dip in the share price of the company.

There was a rise in share price as there was an increase in buying by both the public and institutional investors.

As a result, the PE during this time rose from 87 in Q1FY22 to 102 in Q3FY22 due to the rise in share price.

4)Competitive intensity within the industry:

If there are very few players in an industry, the market will perceive this industry as a high entry barrier industry and therefore will give a high PE to the players in that industry.

An example of such an industry is the Fluorination industry.
The big players in the Indian Fluorination Industry are Navin Fluorine International Ltd, Gujarat Fluorochemicals Ltd and SRF Ltd who control almost 80% of the Indian Fluorination Industry.

The entry barrier in this industry is the handling of fluorine which is a highly reactive chemical requiring the use of advanced capabilities and technology which most players don’t have.

As seen from the image, the valuation ratios other than PE are also on the higher side which indicates the market perception for this industry.

5)Structural or secular industry:
Here we will understand how the market perceives the growth of a company over time with the examples of HUL, Tata Elxsi and IEX
Let us understand the example of HUL.

The company has doubled its earnings in the period of 2015-2022 and the EPS also has almost doubled during this time period.

The market perceives HUL as a company which has and will have stable earnings and cash flow in the long term and due to these reasons HUL trades at a PE of almost 61 right now which was at 52 in FY15.

Let us now understand the example of Tata Elxsi. Tata Elxsi was trading at a PE of around 15 when it had posted net profits of ₹256 crores in FY20. The earnings almost doubled in the next 2 years and the company posted net profits of ₹550 crores.

Before 2020, the market perceived Tata Elxsi to be a low growth stock however when it posted a good earnings growth between 2020-2022, The stock price jumped from ₹1,000 to ₹10,000, the extra 5 times came from the increase in PE from 15 to almost 100.

This is an example where a stock trading at a low PE rose to a high PE.

Let us now understand the example of IEX. The net profits of IEX grew at a CAGR of around 29% during the year 2011-2022.

IEX was listed on 23 October 2017 and it was trading at a PE of 36 at that time. Due to the consistent growth in profits, the PE of the stock rose from 36 in 2017 to around 72 in 2022.

The general perception is that if a stock trades at a high PE, the market expects the stock to consistently grow at a high rate (this is commonly known as growth investing). If this doesn’t happen, there is a reduction in price which leads to a rerating of the PE.

A similar thing happened with IEX. Post FY22, the company almost had a flat earnings profile. The market which was expecting IEX to grow at a much higher rate. When that growth didn’t come, the price of IEX fell from around ₹231 in FY22 to around ₹128 in FY23.

This led to a fall in the PE of the company from 72x and right now it is trading at 40x.

As you can see from the examples of HUL, Tata Elxsi and IEX, the market had a different perception regarding the earnings sustainability of these three companies hence, these companies are trading at different PE levels.

Conclusion:

As we have seen from the wide variety of cases and examples which have been covered, just making your decision based on the PE value won’t be enough.

You will have to look at the other parameters such as the nature of the industry, competitive intensity, earnings stability , earnings growth potential and others to make an informed decision about your investment.

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