Would you like to buy a low P/E multiple Stock ?
We’re sure most of us would answer the above question with an emphatic ‘Yes’. And you may not be completely wrong! In fact, there is ample evidence proving that low P/E stocks have given higher returns as compared to high P/E stocks over the long term. The P/E Ratio has been an all time favorite valuation metric for investors due to its simplicity. It applies the simple logic that a stock trading at a lower P/E than its peers could be mis-priced and therefore has potential value.
But is this always true? Let’s look at an example. Given below is a table of Hindustan Unilever Ltd’s stock price and P/E for the past ten years and Coal India's Stock price and P/E multiple:
Lets look at the above two companies for approximately the same duration of time imagine investing the same amount in the two companies and lets start comparing the based on P/E valuation though the industry's are not comparable. Investing 1 Lakh in Hul would have yielded 718% returns where as Investing in Coal India would have yielded -26.21% returns. With both giving around the same amount of dividend per share. At around 2010 both were trading at P/E multiples of around 20 so what's the reason for the grave difference in returns. Even if you assume investing at the year 2015, P/E multiple of HUL was around 44 where as of Coal India was around 16.71, However looking at the cheap P/E multiple would have made you only loose money because Hul has given 198% in that period where as Coal India has given negative returns of -37.19%
So let us analyse what happend, did anything go wrong?
Lets Analyse the reason for a low PE multiple:
1. Fluctuation of Earnings: The problem arises if the profits fluctuate considerably due to one-time items or because of change in commodity price, like in the current scenario HEG, Graphite India have P/E multiples of around 3-5* due to the spike in prices of the respective commodity, However the past six month performance hasn't been good with both of the falling around 30-40% from their all time high's. Similar thing happened with the sugar commodity in 2008 where stocks returned 20x returns within a period of 2-3 years and 10 years later none of the companies are trading near those levels.
Sometimes, the firm may also face short term problems like fall in demand, etc. Eg: Nestle has fallen Sharply due to ban on its main product Maggie, this led to sharp temporary fall in price and consequently low P/E ratio for the company. In such a case it is important to understand whether the problem is temporary and if the company can overcome it.
2. Low Growth Stock: A stock may also trade at a low P/E if it has low growth opportunities in its current business. These may be companies that have had robust earnings in the past but have little or no growth prospects in the future. Market tends to price these stocks at lower PE than stocks with higher growth opportunities. For instance a company in the textile sector making only spindles, will have little growth prospects unless it diversifies or changes its product line. And this lack of growth will result in lower P/E. Where as a high growth stock will always have a higher P/E multiple. Hence its more important to look at PEG ratio rather than just the PE multiple.
3. Cyclical factor: Cyclical sector stocks go through alternate periods of boom and depression, depending on the demand prospects. As a result of increased earnings during boom periods, these stocks might appear to be available at low PE whereas during periods of recession, they will appear to be expensive due to depressed earnings. Sectors like Cement and Auto are good examples of this phenomenon. An analysis of the sector trends and the median PE is important before we invest in such companies.
4. Industry Impact: The industry to which the company belongs to, also plays a significant role in determining the stock’s PE. For instance, stocks in IT, Consumer Durable's sector are available at higher PE’s as it is considered a growth sector. And there are stocks belonging to the steel sector that always trade at an average PE of 6-10. While we may tend to think that these stocks are available at a low PE, the truth is that such stocks may have had a history of trading at such low PE’s.
5. Promoter Impact : Sometimes the quality of promoters also has a huge impact on the P/E multiple with the market discounting the results or not giving the same valuations to these comapnies. For eg. Pincon Spirits never traded above 10-15x P/e multiple where as the industry was trading around 40-60x P/E multiple and eventually the company declined almost 90% within 6 months.
Thus, low PE stocks are NOT necessarily great bargains!
The first step should always be to check whether the company is fundamentally strong and has performed well in its key parameters over the past. But what if the stock we have found has a great financial track record and none of the above reasons for a low PE? Eureka!! We may be on to a hidden gem. But we need to analyse the PE further. Here are a couple of steps which will help you to make the most of PE – our favorite valuation metric.
1. Compare a company’s PE against its peers: It makes more sense to compare a company’s P/E against its peers because P/E ratios vary significantly across sectors.
2. Look at the Industry PE figure: Industries can be command high or low PE depending on the growth prospects. So, it can help to look at what is the PE for the entire industry as a whole. While calculating this, It is better to calculate the median P/E for the industry instead of an average P/E. The average P/E gets affected by extremely high or low values whereas the median PE does not and hence it gives a better picture.
3. Find a rational PE based on earnings growth of a company: Another way is to assign the company a rational PE, based on all the above factors and our analysis of the company’s growth prospects. The rational P/E should also consider the effects of inflation. P/E ratios tend to contract during periods of high inflation and expand in periods of low inflation.
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