Decoding the PE ratio of a stock

At a glance

  • Price-Earnings or PE is the most widely valuation metric by equity market investors
  • However, arbitrarily shifting PE levels and differences across industry groups mean it’s hard for an investor to utilize it in his decision-making
  • The conservative interpretation of PE should be “the number of years of earnings it will take to pay back your cost of buying a share”
  • Additionally, PE is an indicator of the market’s expectations of earnings growth over a sustained period of time. Working out that expected growth number provides an investor additional information on the suitability of a purchase

Ask a bunch of investors their rationale for buying or selling a stock and chances are you’ll hear “Price-to-Earnings” or “PE ratio” in most responses. It is probably one of the most widely used valuation metrics in the stock market. It’s popularity is in its simplicity, but it also tends to be ill-used in the process of equity investing. While today we’re not going into the weakness of using EPS (the denominator) because of it’s susceptibility to accounting sleight of hand, but just on how, with it’s drawbacks, P/E can offer useful information for the calm investor.

Calculating PE Ratio

Making sense of PE

Since a share represents part ownership in a business, the price of that share needs to have some connection to what the business generates as profit or earnings. PE is one such metric. Now, think about it for a second.

Conservatively, PE ratio can be interpreted simply as the number of years it will take the company to generate enough earnings to payback what you paid for the stock

Not so fast! You’d say, what about earnings growth? Surely stock prices reflect expectations of future growth from a company, so how is that a fair interpretation? Fair enough. Think of it as the “conservative” interpretation, and one that will help expand the utility of this metric.

Flatland – A “zero growth” business

Imagine you were offered a share in the neighbourhood grocery store. It does reasonably well and generates steady annual earnings of ₹10 per share, like clockwork. It is expected to do so for eternity! How much would you pay for it?

  • You’re a long-term investor so willing to think 10 years out

  • But money is forever losing it’s purchasing power due to inflation, so the value of ₹10 years from now is much less than the same amount today. So you discount the future cash using your opportunity cost of funds, namely, the deposit rate you’d get at a bank. Let’s say that is 9%

Flatland Cash Flows

  • But then the business won’t cease operations in year 10 and will find a willing buyer who will again value the steady stream of cash he’ll get. To assign this, we apply the concept of terminal value, in this case, that value is for a never-ending stream of cash-flows

Valuing a no-growth stock

Sidenote: It’s not a coincidence that the ‘terminal value’ we calculated for year 10 is the same as the value / share today. Since we assume the business will continue to generate those earnings in perpetuity, the value today is the same as the value 10 years hence!

Notice how the “fair value” of shares of the grocery store with no growth but assured earnings are worth 11x current earnings.

Growcery – A growth business

Now, assume that another businessman comes along who offers you part ownership in a business – Growcery, that also generates ₹10 in current earnings but will show “significant” growth over the next few years at least. Intuitively, we can tell that the value of a share of this business would be higher than the ₹111 we were ok to pay for the grocery store.

You don’t want to be too extravagant and assume that the business can grow at a fair clip of 10% / year for 10 years after which it will level off earning what it did in year 10 into the future.

Sure enough, the value of a growing business is significantly higher (85%) higher than one that’s not, all else being equal. Notice also how the P/E jumped from 11x to 21x on the promise of growth.

Chart below shows what those acceptable current PE values would be for annual growth rates ranging from 10% to 25% for our growth business in the above example. Remember they all delivered the same ₹10 in earnings in their most recent year but with wildly varying growth projections! Note how an increase in market expectation of annual earnings growth from 20% to 25% would move current price from ₹390 versus ₹530, a 36% upmove. The talking heads on CNBC like to call this phenomenon “re-rating”

In summary:

  1. Current PE ratio of a stock tells us the rate of earnings growth that the market expects from the underlying company
  2. These expectations are highly sensitive to delivered growth levels. Higher these expectations, the more drastic the fall in share price due to even minor misses in growth

 Sanity checking what the market expects

Here’s a rough check I did on pharmaceutical company Cipla :

  • Share Price (as of Feb 2nd, 2015):  ₹695.6
  • Earnings per Share (last 12 months): ₹17.29
  • Current Price-Earnings : 40.2
  • Solving for the rate of growth that will deliver the Value / Share of ₹695.6, expected annual growth rate is 17.9% over at least 10 years

  • Looking back over the last five years, the annual rate of growth has been 6.4%. The highest earnings growth was 34% and the lowest was -11%

Disclosure: Cipla is currently a part of my portfolio 

So, given a PE of a stock, we can

  1. Impute (calculate) the expected growth rate in earnings over the foreseeable future
  2. Compare this expected rate against historic growth rate and question the feasibility of those expectations

Notes of caution:

1. The extensive look at PE in this post might have left you with the impression that I advocate this method of modeling earnings to value and buy stocks. This is not the case. In fact, earnings, especially using most recent year earnings are a notoriously fickle metric for any company given volatility and ease of manipulation of accounting standards adopted. As a popular valuation metric that most investors track, PE ratios provide a window into what the broad market expects companies to deliver over the next few years in terms of growth and flag potentially expensive and particularly cheap stocks

2. We’ve done a simplistic calculation based on earnings only. For a shareholder, it’s not just the earnings, but his cash-flows in the form of dividends and price appreciation that matter. Typically, the company will need to retain part of its earnings to invest in future growth which in turn will result in growth in earnings and dividends.

References:

Understanding time value of money – Investopedia

How to use P/E and PEG ratio to tell a stock’s future

 

3 thoughts on “Decoding the PE ratio of a stock

  • February 3, 2015 at 11:38 am
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    Hi.Can you provide the cipla like example for Page industries. Also can you share the excel model to calculate implicit rate of growth for any PE level.

  • February 3, 2015 at 12:28 pm
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    Hi Ani. Here’s the same view for Page Industries. Expectation of nearly 30% earnings growth over 10 years. Steep!
    Page Industries Price-Earnings Decoded

    Currently, you need solver to work out the growth rate. Will figure out a way to allow use online.

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