Personal Finance: The Trouble With P/E

PERSONAL FINANCE
The Trouble With P/E

Is that it's a good measure of current investor interest in a stock, but hardly the right indicator of its future potential or risk. To pick a fail-proof winner, look beyond the price-to-earnings (P/E) ratio.

By Shilpa Nayak

Here's something I'd bet my last rupee on: that when it comes to buying a stock, the first question you ask your broker, or yourself, is ''what's the P/E?'' By that, of course, you mean what is the stock's earnings per share (EPS) and how much premium (as reflected in the stock price) is the market paying for it. You would probably buy the stock if you discovered that the price-to-earnings (P/E) ratio was lower than those of comparable stocks. The rationale being that once investors wake up to the fact that the stock does not adequately reflect its future earnings potential, there will be a rush to buy it. Similarly, you would steer clear of it if it has a high P/E, indicating that it is overvalued.

On the face of it, the reasoning is infallible. If something is being sold at a discount, people would want to buy it. And if it is overpriced, they wouldn't, right? But when it comes to investing in stocks, going by earnings alone won't do the trick. For instance, a company could be making more money selling assets, writing back provisions, cutting back on depreciation or changing other prudent accounting norms. It would be a mistake to assume that money is money, no matter how it is made. For, in the next year, or quarter, the company may not be able to show similar gains.

Then, there's the "buy low sell high" trap you need to avoid. A high P/E is not necessarily a sign of a stock price peaking. Take Dr Reddy's Labs, for instance. The Hyderabad-based pharmaceutical company has traditionally enjoyed a higher P/E compared to some of its peers. But that hasn't prevented DRL's investors from hitting pay dirt. In the last two years, the DRL stock has doubled to Rs 1,400. So, just what did these investors see in DRL that a P/E disciple would not have? Four factors: The potential for growth in revenues; a high Return On Capital Employed (ROCE); a low debt burden, and the quality of management. The next time you want to make a buy decision, put the stock through these four filters.

Watch The Topline

Profits, the anticipation of which drives stock prices, can come only if there is revenue to start with. Ergo, analysis of revenue growth is essential. What you do is this: look at the company's net revenues (minus excise duty), and divide it by the number of outstanding shares. That will give you the revenue per share. There are some thumb rules that fund managers go by. Most of them would tell you that a stock's price should not exceed 10 times its revenue per share. Some others would be a little more aggressive and stretch it to 11 or 12 times. But, here's a caveat: most rules are not applicable across industries.

What you need to ensure is that the growth is sustainable. It's easy for all companies to ride a boom, but when there's a downturn, only the best manage to grow. Consider the recent slump in infotech. Cybertech and RS Software, which grew at scorching rates of 40 per cent and 70 per cent, respectively, during 2000-01, have since seen their profits and growth take a sharp dive.

Track Return On Capital

Investors like companies that can stretch a rupee farther than their competitors. Making higher profits on a bigger capital base is easy. But making more money out of less money year after year is what determines the success of a company. The ROCE, as a concept, is an important tool in valuing stocks. Companies like Wipro, Infosys, HLL, NIIT, Hero Honda, and Castrol have had consistently growing ROCE.

The company's operational efficiency will pay over a longer period, especially in a recessionary environment. The market will accordingly assign a higher earnings multiple to a more efficient company (all other things being equal). Bajaj Auto, whose ROCE has slipped from 30 per cent to 20 per cent in the last three years, trades at a P/E of 10 versus Hero Honda's 12.

Cash flow is another thing you should look at. Put simply, cash flow is nothing but money that flows in and out of a company. But it can tell you a lot about how the firm makes its money. For example, the PBDIT (Profits Before Depreciation, Interest and Tax) could be high for a company, but the money could have come from investment activities or sale of assets, while the core activity may not be generating much cash.

Shun Debt-Heavy Stocks

Although debt helps the company to substitute owners' capital in times of rapid growth, it comes with a risk attached: fixed interest outgo. If the industry faces a downturn, then players with huge debt on their books will be the first to face the heat, because their interest outflow remains constant even as their profits and revenue fall. Hence, a company with a higher leverage will be accorded a lower P/E multiple by the market.

There are some sectors that are capital intensive and, hence, are highly leveraged. Cement, steel, and oil and petrochemicals are some of those. Pick up any profit and loss statement, and you will find that interest charges are a big item of expense. Had the company been more efficient in utilisation of its funds (our previous point), a big part of the interest payment could have been saved. That, in turn, would have added to its earnings, boosting stock price.

In fact, companies are known to turn sick, simply because they were highly leveraged. Investors are only too aware of it, and make it a point to show that in the stock's P/E. Small wonder, then, that even well-managed companies such as Gujarat Ambuja are trying to pay off expensive debt to improve shareholder value.

Invest In People

A company is only as good as the people it employs-especially at the top level. Every aspect of the business-what products to launch, how to price them, which segments to tap, whether to export or sell locally, financial management and every thing else-is determined by the company's managers.

Not only does the management need to be good, it needs to be transparent too. And investor perception of the management determines the stock price. Infosys, despite its recent earnings guidance, is still commanding a higher multiple than HCL Technologies, which has been able to maintain a good growth rate.

Some Indian promoters are notorious for inter-group dealing and investments, and for siphoning of funds from listed companies into their private-owned firms. Such groups are pariahs in the stockmarket, and even if they turn out sterling results, the markets will always be skeptical of them. So, steer clear of such companies.

The moral of the story: if P/E tells you that a stock is undervalued, then it probably deserves to be so. To pick a winner, look beyond P/E.

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