Friday, 28 December 2012

Stock Valuation - More on PE

In our post on Valuation by PE we discussed how PE gives more insights than CMP when valuing stocks for investments. Let us continue with some detail discussion about PE ratio, which may help us in learning to invest better.

PE ratio reflects the
expectation of the investor from the company and its growth outlook. It reflects the price the investor is willing to pay for the company’s share for the company’s future earning prediction. It is more a reflection of expectations, sentiments and growth projection of the company/sector. Let us look at some points so that we can learn about PE in a better way before we invest in stocks:

  • High P/E ratio suggests expected high growth rate of the company and future earnings. For high growth sectors the P/E ratio generally tends to be high and ratios of 25, 35 or 40 are normal for sectors like consumer goods etc.
  • Low P/E ratio suggests expected low growth rate of company. Slow growth sectors like power etc. generally have P/E in the range of 6, 10 or 12 and such low P/E are normal for such sectors. It does not mean that they are any cheaper. It is just a reflection of the sector and the company’s growth rate.
  • When a company’s growth projection and core business expansion (capex) justifies a high valuation in advance, we generally see the stock price increase. This is a function of Future forward P/E valuation  to its current P/E.

What is future forward P/E ?

While reading any analyst's report on a company and its outlook, it is common to come across the mention of future forward PE. It is important to know about this term when investing in stocks

Lets take a company XYZ which has maintained a sales CAGR of 20% with a profit CAGR of 25% so far.  Lets say that it is predictable that it will grow with at-least the same rate between FY12 to FY14.Lets say that the share is presently trading at Rs.150/-. Lets take the dummy data of XYZ company as follows :

Equity Paid up Shares
EPS (Profit/no. of Shares)
FY 2012
FY 2013
FY 2014

From this we can state that, in respect of FY14 earning, the company is trading at 9.6PE, taking the present share price of Rs.150/-. This is generally mentioned as the company is trading at 9.6PE FY14. Now assuming that in FY14 the company will maintain at-least the present PE i.e. 15, when the price adjustment takes place, the target price of the stock will be EPS(of FY14)*PE(present) = 15.6*15=234 in the next 12 to 18 months.

The above type of analysis, as it is obvious, is based on many assumptions and whenever such analyses appear in financial analysis, it should be read with due caution.

Some points about PE when investing in stocks :

  • P/E expansion or re-rating of stock price takes place for valuation of a company which is presently trading at discounted price compared to the industry average.
  • The stock price may be affected by some news about the company like takeovers, selling a portion of existing business, increasing product line-up which has a contribution to its top-line etc.
  • Companies having higher competitive advantage trade at higher P/E
  • Whenever there is a disconnect between the present stock price and future earning growth of the company, the P/E will eventually change to reflect the outlook correctly.

Lets take an example. Nestle and GSK consumer healthcare are both companies in the same sector. Nestle is trading at a P/E of 38 to 40 and GSK CH at a P/E of 31 for FYE13 earnings.

GSK CH is the second largest company by sales, is engaged in malted food drinks and is also diversifying its product line-up with many new products under the trade name Horlicks. It has a sustainable potential growth in the Indian market.

Nestle, on the other hand, is the largest company by turnover in food processing business. Its product line-up is much more extensive due to which it has a competitive advantage and hence the higher P/E.

So, in this post we have learnt a little bit more about investing by stock valuation. Learning to invest in stocks is a lot more easier and becomes a lot more logical if you learn about stock valuation. Using valuation in the correct way makes you better stock investors.