Let’s get a little technical…

So the carnage continues on the market! The week that went by, saw more correction on the markets, and even though there was some recovery, all in all, it was a downward movement. If you ask a dozen experts, you will get a dozen different reasons to explain this. From the dollar-rupee rate, to the FII money drying up, to a bear grip on the market, reasons are many. The bottom line for a retail investor is that the market is slipping ground. There is every likelihood of recovery, and maybe sooner rather than later. But for the moment the market has moved southwards.

So as a prudent investor, what do you do? The answer lies very clearly in one of my early articles. The answer is that you need to have a target profit number, which if you reach, you are better off selling and booking profits. And likewise, you have a stop loss target, so that if the stock starts moving down, and reaches that target, you will sell off, and ensure that you stop your losses from increasing.

It takes a lot of discipline and focus to follow the above principles. When the stock is moving upwards, one tends to be greedy to want more, and does not sell off, and book profits. Only to see the market going down later, and the paper profits disappear. Likewise, when the stock moves below the purchase price, there is a strange attachment that many investors get to their stock, and they refuse to let it go, even as the receding price of the stock keeps eating away on their capital. It is even more important to sell to stop losses, than it is to sell, to book profits.

If you HAVE followed these fundamental principles, without getting panicky or desperate, you will be sitting with a cool head, and calm comfort, waiting for the next opportunity to buy or sell. For the rest, who did not follow the simple advise, well, I presume you may not be left with much nails on your fingers, as you might have bitten them all off, as markets kept sliding down in front of your eyes!

Anyway, let’s get to the main topic of this week’s article. And as the title says, we are going to get just a wee bit technical this week. Yes, I remember my promise from the first article, that I am addressing amateur retail investors, and I will refrain from using any technical terminology. And all of the last several weeks’ pieces have strayed away from the technical issues. And in a way, you are sufficiently well equipped even without the technical knowledge, to invest and make money from the stock markets. However, for the benefit of those who want to understand one simple term, viz. P/E ratio, I am going to devote this piece to the understanding of that. And I promise to make it so simple that as an amateur retail investor, you will surely get it!

Lets forget the stock markets for now, and just look at a company, where you may consider investing. Say, the company has given out 1000 shares. And this company makes a profit of Rs. 10,000. Very simply put, if this profit had to be distributed to individual shareholders, how much would each shareholder get? Rs. 10, right? Well, then Rs. 10 becomes the ‘earnings per share” or EPS as it is known.

Now if there is someone owning a share of this company, and he wants to sell it to you. What will be the minimum price that you will be willing to pay? Well, it has to be Rs. 10 again, as that is the ‘earnings per share’ and conceptually that amount is yours for the taking. So indeed the minimum price that you will be willing to pay for the share is Rs. 10.

However, note that you are going to become a shareholder by purchasing this share, and you will not just get the fruits of this year’s earnings, but of future earnings of the company as well. So you may be willing to invest a little more than Rs. 10. How much more will you invest? That will depend on your perception of how the company is likely to do in the future. You may believe that the company may continue to earn the same amount for at least 3 more years, and you are willing to take your bets up to that period. Then, you may be willing to purchase that share for Rs. 30, rather than just Rs. 10. On the other hand, you may have a feeling that the company is not only going to make profits for future years, but it is poised to increase its profits substantially, over the next few years. Say, you may estimate that the profits will be 3 times the next year, 5 times the year after, and 10 times the year thereafter. In such a case, you may be willing to pay a much higher sum for that share, say, even Rs. 100 or Rs. 120, as compared to the original Rs. 10. Whether it is Rs. 30 or it is Rs. 100 or it is Rs. 120, what you are paying is a MULTIPLE of the present “earnings per share”. Remember that in the above example, the present earnings per share were Rs. 10. When you pay Rs. 30 for that share, you are paying a multiple of 3 times the EPS, and when you are willing to pay Rs. 120 for that share, you are willing to pay a 12 times multiple of the EPS.

I trust that you have understood the above. As soon as you nod in confirmation, you have also understood then, the concept of P/E ratio. Yes, in the P/E ratio, P stands for the price of the share, and E stands for EPS or earnings per share. And hence, the P/E ratio is nothing but the multiple to the EPS that the price commands. When you were willing to pay a PRICE of Rs. 120 for the share, whose EPS was Rs. 10, the share had a P/E ratio of 12.

In the real world of companies whose shares are listed on the stock markets, the scenario is same, but at a larger scale. Instead of the 1000 shares that the company in the above example had, most listed companies will have lakhs of shares that have been issued. But the principle of EPS and P/E ratio remains the same.

The other thing to appreciate is that out of the two factors in the P/E ratio, the “E” part, i.e. the EPS, does not change on a day-to-day basis. Even though the company operates its business daily, it does not release it’s accounting information on a daily basis, so we only know the EPS based on the last declared financial results. Also in reality, the earnings of the company generally move as per some gradual movement that has already been envisaged and predicted. Large variations in the EPS are unlikely. So in the ratio P/E, the E part remains largely steady. It is the P part of the price of the share, which is dynamic and will tend to change daily or even hourly, based on the perception that investors have, about the company, and where it is headed. Change in the price, then gives a change in the P/E ratio. Or knowing some facts about the company, its present P/E ratio, an investor could hazard a guess as to its likely movement on the P/E ratio, and then, you can take an educated guess, whether it’s a good time to buy the stock or to sell it, or to just stay put.

How does that happen? Let me give you some idea of this.

1. Typically an industry sector may have an average P/E. Say, for example, the 2-wheeler industry has a P/E of 15. Which is nothing but an average of the P/E of the various industry players. Now, if Bajaj Auto has a P/E of 14 and Hero Honda has a P/E of 16, what does it say? It would say that for some reason, perhaps due to the future prospects that the market perceives, they have given a better appreciation to Hero Honda stock than to Bajaj Auto. Now if Bajaj Auto comes out with good results, then there is a good chance that its share price may rise to make its P/E at least 15, if not beyond that. On the other hand, for Hero Honda to appreciate further, it must come out with something more outstanding, and substantial, for the market to give it a multiple even beyond the premium that it has already given to the stock. Moreover if there is any adverse news about Hero Honda, the stock is likely to slip sharply to levels where its P/E goes down to 15 or 14 (Bajaj Auto’s level) or maybe even lower than that.

2. There is a chance that due to some bad years of performance, in an industry sector, a particular company has got badly hit, in terms of its share price. Where the industry average P/E is say, 15, this share price has been hit so badly, that its P/E is dwindling at 5. Now suppose there is news that due to some restructuring or whatever, this company is turning around in its performance. And if it is believed that it will soon come close to the rest of the industry peers, then just imagine the room that this stock has to grow. Since its P/E is only 5 and the industry average is 15, then the price can move significantly up, before its P/E level reaches somewhere close to 12-15. That may suggest a great buying opportunity then. This, in fact, is what has happened to many PSU companies whose shares are quoted on the stock market. PSU banks’ stocks are also examples of this type.

3. The P/E ratio also explains the astronomical rise of some stocks in the ‘new-age’ industries like say, IT, Media, Biotech, etc. The market somehow believes that the earnings of these companies will rise at a very fast pace, as compared to more traditional old economy companies. Which means that over the years, the “E” part of the P/E ratio is going to keep going up rapidly. That being the case, the market pre-empts the scenario and gives a big premium of the price multiple today itself, and that results in a high P/E ratio. The IT industry commands a P/E of more than 50, the pharma industry commands a P/E of around 32 and the FMCG industry (on account of the expected growth in this sector due to the large buying power of India’s middle class, perhaps) has a P/E of around 34. This is compared with P/E of 18 for cement industry, 10 for engineering industry, and 6 for Power sector companies. You can well see what the market believes about the future prospects of these industries. By the way, all this information of P/E for individual company or for an industry sector, is available on the website of equitymaster.

4. Sometimes when our stocks are rising to great heights, we may question the logic for the same? Do these stocks justify such a price level? One way to validate these doubts is to again look at P/E levels. What is the average P/E in a developed market like the US stock market? What is the average P/E level in some other emerging markets, like say, Brazil? What is the P/E level say, for the leading bank stock on the Wall Street? How does that compare with the P/E level of India’s leading bank stock, State Bank of India? Comparisons of this nature can give us answers as to whether our markets are overheated or in fact, they are slowly catching up with the world, in terms of the P/E multiples that we have given. The latter may point to a maturing of the markets, in fact. To give you the actual answer, indeed, our markets are maturing, and our P/E levels on an average have been lower compared to the better markets of the world, and in fact, there is still a lot of room to catch up with the world P/E multiples. Again then, if we believe that the India story is happening, we should not be surprised that our stock prices are rising, as we are only closing in to the P/E levels commanded in other world markets.

5. A note of caution about understanding P/E. Where the above guidelines are theoretically correct, there is a question of understanding what data you are seeing. You may see an EPS of a company today. Do you know clearly, if that EPS is of April 1, 2004 results, or based on quarterly results for quarter ended on December 31, 2004 or in fact, these are the projected EPS for year ending 31st March 2005? When you compare P/E for different companies or in an industry sector, are you sure if the EPS taken for comparison is the same period one, for both? There are times when analysts refer to “forward P/E”, there are times when the P/E is based on last year ended results, etc. It is important to be clear of the data behind the P/E ratio to ensure that the correct comparison is made, and action taken based on the data, is also correct.

Yes, it is a technical issue that we have covered this week. Those of you who are able to understand and utilize this understanding well, will have an additional weapon to combat the markets. Those who choose to let it pass, are also okay, as the earlier discussed principles which are simpler to understand, will still carry you through the minefield of the marketplace!

Till next week, then. Take care….
Sanjay Mehta