The P/E Conundrum - How to take advantage from it!

"....the forward earnings multiple is attractive and we suggest a buy rating on the stock." 

How often have you heard the above lines in the morning talk shows at CNBC, ET Now etc? You will find almost every analyst talking about the "P/E multiple" as a base for stock picking. And poor investors like us often get trapped in what I call The P/E Conundrum! And believe me, the conundrum is good and if you learn how to solve it, you will always have an edge over others in picking the right stocks!

P/E represents the ratio of price of stock over its earnings per share. For e.g, a stock trading at 150 per share with EPS(earnings per share) as 10 will have a PE ratio of 15. A PE multiple or ratio suggests how much price you are willing to pay for a stock in terms of its earnings. If you believe that the company has a great growth & earning potential, you will tend to pay a higher multiple of its earnings. In 2012, when Facebook went for the IPO, the market was ready to pay more than 100 times its earnings for the stock. We all know that how facebook crashed to almost half of its listed price with a subdued PE. 

There is no denying the fact that P/E ratio helps in decision making for most of the hedge funds, money managers and individual investors. The father of value investing, Benjamin Graham often used P/E as a guide for finding right stocks. A company with sound business operations trading at P/E multiple around 14 used to be his value pick. However, P/E has its own pitfalls and gaps, and all we need to do is to understand those limitations. The three golden rules which you should never forget are:

• The P/E ratio works only for profit making firms who have not reported significant deviations from their past earnings. Don't use it for growth stocks or firms which you think have reported huge changes in their earnings without any significant move in their top line or bottom line growth.
• P/E alone cannot be used to estimate the intrinsic value or for relative analysis of the stocks. You should consider the net debt, cash balances too
• P/E depends not only on the future expected growth but also on the cost of capital for the firm. Two companies with the same P/E doesn't necessarily mean that they are expected to grow at the same pace!

Now, let's resolve the conundrum and see how we should use P/E to value a firm, and also what P/E should be considered as the "right" P/E. The chart below shows the P/E ratio of CNX Nifty stocks for the last two years.

The PE ratio has been  mostly in the range of 17 to 20, but we do observe them touching as high as 26. So what do we make out of these numbers?  Also, Larsen & Toubro is trading at a PE multiple of 18, while ITC is trading at a PE ratio of 35. If that was not enough, BHEL is trading at a PE of 7. Three large caps, all profitable and yet such a different PE! The conundrum, isn't it?

So the first challenge is  to ensure that we estimate a right PE, and then to estimate the margin of safety in using it for stock picking. We neither need to be too conservative and miss the opportunities nor be aggressive enough to buy at a high valuation. I will now give a simple tool which shall help you in finding the fair value of any stock. This definitely can't solve the conundrum in whole but will certainly help you to avoid expensive stocks and help select cheap ones.

As I have stated earlier, the PE depends on the the cost of capital for the firm as well as the expectation for future growth. Theoretically speaking, the inverse of PE is analogous to the yield of a fixed income security. Hence, it depends on range of different factors. The table below can give a fair estimate of how the PE should be:

So If you see the matrix above, you can estimate the fair PE value for any firm for which you know the growth rate and its balance sheet.  Now growth rate is something which you can find from the earnings report and then qualitatively estimate the future trend. Similarly, a firm which has high capital value, less debt and financially more sound will have a lower cost of capital compared to the firm with a high debt and more volatile earnings. Let's use the table to estimate the intrinsic values for few well known stocks.

ITC:  ITC is a very stable firm that has shown a growth of about 25% YoY. It has a wide range of business from tobacco to agriculture products, FMCG, hotels etc. It is fair to estimate that it will grow by 20% for the next 5 years. Also, if you see the balance sheet, ITC has negligible debt making the cost of capital small i.e. around 10% to 12%. So let's find the PE from the table above. Using our estimates, the PE for ITC should be in the range of 28-32. It has 3000 cr in cash and bank deposits. So it is fair the estimate that the PE should be about 32. With EPS of 9.4, the fair value of stock comes as 300. ITC is presently trading at 330. So any price below 300 should be a value pick. Please note that the 3 month low of ITC is 281 which was a value pick point.


L&T: Let's try this for Larsen & Toubro. Now this is an infrastructure company which has huge debt and also has a lot of project risk. It is fair to estimate the cost of capital to be around 16%.  The top line has grown by about 20% over the last few years and is expected to maintain so. Now, if we pick the PE number from the table above, i.e. for 5th column (20% growth) and 3rd and 4th row, it comes in between 22 and 25. It is fair to estimate the PE as 22 to be on safer side. Please also note that L&T has about 12,000 Cr of debt which translates as 196 per share. So, using the EPS of 79, we get the fair value of L&T as (79 X 22 - 196) which is around 1541 per share. L&T is presently trading at 1456 with a 1 month high and low as 1652 and 1407. This means that anything below 1500 is a value pick for L&T.

So what we have seen here? Regardless of where the market is trading presently, you will always find days when the traded price touches the intrinsic value and that is the time when we should use the value picking strategy. I hope the PE table above shall not only help you come out of the conundrum, but use it for your advantage.

If you want more clarifications on how I have created that table or how should you use it, please feel free to connect with me at LinkedIn. Happy Investing!