Ajitansh Kar, Gurugram, 5th October 2022
While starting to learn about investing, many people are introduced to the Price-to-Earnings (PE) ratio which is a simple yet very powerful valuation ratio to check out for while studying about a company or evaluating its valuation. There are hundreds of articles and videos on the internet explaining this ratio; but today, I am going to give you a different perspective on how this ratio works and how to use it to evaluate a company’s valuation properly.
Let us first understand what the PE ratio is and what it signifies. The PE ratio is a type of valuation ratio that tells us how cheap or expensive the share or stock of a particular company is with regard to its current market price. The ratio is simply calculated by taking the current market price of a stock and dividing it by its EPS (Earnings Per Share). This tells us about the premium or the discount at which that particular stock is trading. As an investor, our primary goal is to buy the stocks of the best companies at the cheapest price available and the PE ratio helps us in determining that to some extent.
In most articles or videos which you see about the PE ratio, the synopsis would be that any number below 20 for the PE ratio is cheap while anything above 20 is to be considered as expensive. This point according to me is invalid because it does not essentially provide us with the correct information in order to identify if a stock is undervalued or overvalued. Instead, we should be focusing more on the EPS part of the analysis and try to see if the earnings of the company have seen any significant growth over a particular time period. We should also look at the difference between the returns generated for shareholders on their investment in the stock of a company and the growth in profitability of the company over a particular time period in order to see if we are overpaying for a particular stock or not. This is so because in the long term it is a company’s profit which drives the growth in its stock price.
Let’s understand these arguments better by comparing two big companies of India – Hindustan Unilever Limited (HUL) and Coal India Limited (CIL). Though these companies belong to different sectors, for simplicity purposes we will use these two companies as our examples to highlight how to effectively conclude the valuation of a company using the PE ratio.
HUL quotes at a PE of 69 while Coal India quotes at a PE of 5.7. A novice may look at both these companies and conclude that HUL is more expensive than CIL and hence, it would be better to invest in the latter. This would be totally wrong and let us see why. Let us dig deeper and look at the profitability growth of both companies as well as, the returns generated by these companies for their shareholders over the past 5 years. HUL has given a CAGR (Compounded Annual Growth Rate) of 16% to its shareholders while its profits have grown at a CAGR of 15.6% over the past 5 years. The growth in profits is phenomenally high as HUL belongs to the FMCG (Fast Moving Consumer Goods) sector which has an average profitability growth of around 10-12% in terms of CAGR (5-year time period). On the other hand, CIL, which is a Maharatna company belonging to the Mining and Mineral sector, has delivered a CAGR of -5% to its shareholders and has a profitability growth of only 13.72% in terms of CAGR in the past 5 years. In the case of CIL, the profitability growth is less than the industry average of CAGR of 22.5% (5-year time period) and has other bad fundamental characteristics, which has led to the erosion of investors’ capital.
I hope that you now have a better understanding about the PE ratio and would analyse it more deeply when studying about a company or business rather than looking at it in terms of absolute numbers.
