Framework to understand price-earnings ratio

Let's hear what the legends have to say about the price-earnings ratio.

It's nonsensical to derive a price/earnings ratio by dividing the known current price by unknown future earnings. -Benjamin Graham

Now, let us read what we have to say about it.

Many investors simply look at the P/E ratio to draw conclusions about a stock's valuation. They often believe that a high P/E ratio indicates overvaluation, while a low P/E ratio suggests undervaluation. In a more extended and humorous version of this idea, some might say that a P/E ratio above 30 means a stock is overvalued. They think putting a number will give such practice more meaning. 

However, relying solely on the P/E ratio can be misleading. While it can sometimes be useful, particularly at the extremes, it is not a comprehensive measure of a company's value. Each company tends to have a historical range for its P/E ratio, with smaller companies experiencing larger fluctuations. When a company trades at the lower end of its historical P/E range, it often indicates undervaluation, and vice versa.

Nevertheless, it's important to avoid looking at the P/E ratio in isolation, as doing so can hurt investment performance. Instead, the P/E ratio should be integrated with other investment parameters, such as the return profile (ROCE, ROE, net profit margin, cash flow from operations as a percentage of operating profit), the competitive advantage of the business model, and the durability of such an advantage.

Below, we present a framework for considering the P/E ratio when making investment decisions.

When to Ignore or Give Less Importance to the P/E Ratio

1. Small-Cap or Micro-Cap Companies: For these companies, the P/E ratio is less relevant. Instead, focus on understanding the business model, earnings growth visibility, and triggers for future growth. A high P/E ratio in small companies can quickly turn into a low P/E ratio due to high earnings growth potential. For example, HDFC stock was trading at over 670 P/E in 1995 during its listing, with a market cap of 800 crore.

1. Cyclical Companies (e.g., metals, sugar, commodities): These companies behave differently from defensive sectors like FMCG. Contrary to popular belief, cyclical companies should be considered when their P/E ratios are high. This typically indicates they are at the bottom of their cycle, where profits are low and P/E is high. As the cycle turns and profits increase, the P/E ratio decreases, indicating a time to exit.

1. Corporate Actions (demergers, mergers, acquisitions, restructuring): Such actions change the company's story and trajectory, making the P/E ratio less relevant.

1. Negative P/E Ratios: When P/E ratios are negative, they are not useful for evaluation.

P/E in the case of Large-Cap Companies

For large-cap companies, the P/E ratio can provide a sense of valuation, as it is difficult for these companies to grow earnings by 25-30% for extended periods, regardless of their quality and competitive moats. Consider companies like Asian Paints and Pidilite. Despite being extremely strong franchises, these companies have delivered minimal returns over the last three years.

In January 2021, Asian Paints had a P/E ratio exceeding 100, an absurd valuation. The P/E ratio has since halved to 51.

Look at the stock price, it has been sleeping since 2021

While one could argue that Asian Paints might deliver 20%+ returns over the next 15 years thus it is a great investment, consider the following questions before making such conclusions:

1. Is my investment capital large enough? Large capital faces liquidity disadvantages thus it is limited to large-cap companies, while smaller capital can find better bargains elsewhere.

2. Do I have the patience to hold for long periods and endure phases of no stock price movement? Large-cap stocks often go through time corrections.

3. Even if I hold for 15 years, will the returns be sufficient to significantly impact my net worth?

If the answer to these questions is NO, then pursuing large-cap opportunities at stretched valuations is not wise. Instead, consider opportunities in demergers, other special situations and opportunities in small and mid cap space. We have covered demergers [here].

Mean reversion in large caps

Before concluding, it’s important to note that if these great franchises revert back to their historical mean valuations, they could represent excellent investment opportunities. Getting the entry point right (i.e. fair valuation) can create a meaningful difference in the wealth creation journey and is one of the important criteria while investing in large caps. 

You might then wonder why star fund managers frequently discuss these quality companies without paying much attention to valuation and price. 

The answer is simple, it is career fixation, meaning no one is going to throw you out when you own such names, you can always make beautiful stories around these great companies and deliver 0 returns for many years and still make money from management fees. This is the power of these great quality companies, it makes money for the fund managers but not for you.

So next time you are looking the the price-earnings ratio you know how to make sense of it.

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Disclaimer: This article is for information purposes only, and not to be considered as investment advice.