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Showing posts with label PE Ratio. Show all posts
Showing posts with label PE Ratio. Show all posts

Saturday, December 8, 2012

Historical & Expected PE Ratio of Indian Stock Market

P/E ratios in India during 1990 and 2005

As of December 31, 2009, there were 23 government-recognized stock exchanges in India and there were more than 9,700 companies listed on these exchanges. The Bombay Stock Exchange (BSE) lists about half of these companies (4,929).

BSE happens to be the oldest in Asia, having been established as "The Native Share & Stock Brokers Association" in 1875. As of December 31, 2009, the market capitalization of the companies listed on BSE was approximately USD 1,400 billion (approximately 1.1 times India’s annual GDP).

Since BSE has the most well-known indices within the Indian stock market, we focus on a few of these indices in this article: SENSEX (with a base of 100 in 1978-79), BSE-100, and BSE-500 (with a base of 1,000 in 1999 and comprising 500 listed companies in various Indian stock exchanges).

Ignoring dividends, both SENSEX and BSE-100 have grown by 13.4% annually in Indian Rupee terms during April 1, 1991 and March 2005. On March 31, 2005, SENSEX was valued at 6,492.82 (with a P/E ratio of 16.05) and BSE-100 was valued at 3,481.86 with a P/E ratio of 13.72. This growth rate can be partitioned into the following three components:

1. The companies comprising SENSEX and BSE-100 have individually grown at an average annual rate of 9% or more (in real terms) and 15% (in nominal terms).

2. As shown in the table 1 given below, the price-earnings ratio for companies listed in SENSEX went down from 19.68 in March 1991 to 16.05 in March 2005, i.e., an average drop of approximately 1.5% per year. Similarly, the price earnings ratio for companies listed in BSE-100 dropped by approximately 2.4% per year.

3. The difference between (1) and (2) approximates the average annual growth rate of SENSEX and BSE-100 of 13.4% as mentioned above.

Predictions regarding the Indian Stock Markets during 2005 and 2015

The following three main components are likely to result in a strong upward movement of Indian markets:

1. During April 2005 and March 2015, companies listed in SENSEX, BSE-100, and BSE-500 are expected to grow at an annual average rate of 11% (in real terms) and 17% (in nominal terms).

2. In March 31, 2005, the firms in SENSEX were trading at an average P/E ratio of 16.05 whereas they were trading at an average price earnings ratio of 22.8 during 1991 and 2005. Our analysis shows that by December 2015, these firms (that are part of SENSEX, BSE-100, and BSE-500) are likely to trade at an average P/E ratio of 22.8 also, partly because of volatility and partly because the annual growth rates of these companies is quite high when compared to their counterparts in the United States and other developed countries.

3. As a comparison, during the past fifteen years, an average firm in China’s stock market has been trading at an average price-earnings ratio of 23. Clearly, on one hand, since the stock markets in the United States are much bigger and more mature, the companies listed there likely to command a higher premium; on the other, since these earnings are computed on the “last twelve month” basis and since the companies in India (and other emerging countries) are growing more rapidly – as much as 7-8% more – than their counterparts in the United States, we believe that the SENSEX, BSE-100, and BSE-500 will trade at an average price/earnings ratio of 22.8 (during 2005 and 2015).

Thursday, July 19, 2012

How to Value a Stock - Cheap Vs Expensive?

If you’re new to investing, learning how to choose stocks and investing in the stock market can be overwhelming. Probably the largest mistake that young investors make is to look at the price of a stock as a measure of its worth. In fact, the price of a stock is virtually worthless when trying to value a company.

So what metrics should investors use when evaluating a potential stock investment opportunity? While there are numerous factors to take into consideration, the most popular and well-known metric is known as the price to earnings ratio, or the P/E ratio. But before we get into explaining this ratio, let’s look at why the price of the stock doesn’t tell the whole story.

Stock Prices – Cheap Vs. Expensive

Think about something in your life that you know very well. Maybe you’re obsessed with computer upgrades and performance. You know everything there is to know about computers and when you go to a computer store; when you look at the prices and the specs, you truly know what represents a bargain.

If you were helping a friend pick out a computer, you might tell them that a computer on sale for Rs 20,000 may be a better bargain than a computer on sale for Rs. 18,000. Maybe the Rs. 20,000 computer has a bigger screen, more storage space, and Rs. 5000 of preloaded software on it. With the Rs. 18,000 computer, not only is the hardware pretty shoddy, but there is also no preloaded software, meaning you’ll have to shell out extra money once you buy the computer. You might say “you get more bang for your buck” with the Rs. 20,000 computer. It is this same line of thinking that should be applied to stocks.

Unfortunately, many young investors do not apply the same logic to stock picking. Instead, they look at a Rs. 1250 stock like TCS and call it expensive. So they head to a little known penny stock that is selling for Rs. 0.50 and buy it up like it’s pure gold. The fact of the matter is that if you only have Rs. 2500, there’s a good chance that you’ll make more money purchasing 2 shares of TCS rather than 5,000 shares of that cheap company. Why? Because TCS is a much more stable company with not only a proven track record of making investors money, but also strong growth potential.

The P/E Ratio Defined

Now that we’ve fixed the flaw in the young investor’s logic, let’s look at how to measure value. It’s a little more complicated to evaluate stocks than it is to evaluate computers since there are so many different factors involved.

However, there is one metric which, while it doesn’t make up the entire story, offers an important piece of the puzzle when valuing a company: the price/earnings ratio, often referred to as the P/E ratio or P/E multiple. This ratio, while only one of many that sophisticated investors use, is the most popular and discussed ratio in many investment books.

So how does the P/E ratio work? Think of it this way: let’s say you are considering investing in two public companies, both of which are selling for Rs. 200 per share today. One way of deciding which company to invest your money in is examining how much you will need to pay for Rs. 10 of earnings from each company. If last year, Company A earned Rs. 50 per share and Company B earned only Rs. 40 for share, it would intuitively make sense to choose Company A over Company B since it represents a cheaper trading opportunity. Without even realizing it, you’ve made this decision by calculating each company’s P/E ratios.

The P/E ratio is calculated by taking the current price and dividing it by the earnings per share. In the example above, you would take the price of Rs. 200 and divide by Rs. 50 for Company A and Rs. 40 for Company B, yielding ratios of 4x and 5x, respectively. If you’re not good with math, you can also easily find the P/E ratio in the fundamental analysis section of your broker’s research screens for the stock you’re reviewing or on various stock market investment news and research sites.

Disadvantages of the P/E Ratio

While the P/E ratio is a valuable metric for investors, you don’t want to make the mistake of thinking that a P/E ratio alone tells the whole story. Here are the main limitations of the P/E ratio:

1. Healthy P/E ratios may differ between industries: The concept of using a set P/E ratio to determine if a stock is overpriced fails to take into account the individual nature of the underlying company. Stocks in high-growth industries like the technology industry tend to have higher P/E ratios. On the other hand, some industries such as utility companies tend to trade at much lower multiples. Before you can decide if a stock is under or overpriced, you need to take into consideration the industry in which it operates. Continuing with the example above, let’s say Company B was a high-growth tech company forecasted to earn Rs. 100 per share next year and Rs. 150 per share the following year, while Company A was a low-growth oil company that was forecasted to earn Rs. 60 per share next year and Rs. 70 per share the following year. Now that you have a fuller picture of the two companies, it becomes clear that Company B would in fact be the better company to invest in due to its massive growth potential. Company B’s stock price will likely skyrocket if the forecasts are correct, while Company A’s stock price may not budge by much over the next couple of years. Thus, by ignoring other aspects of the company, an investor might have falsely assumed that Company A represented the more valuable stock opportunity.

2. Fails to consider the debt of a company: The price of a stock reflects the equity value of a company. However, it is also important to consider how much debt the company holds. An investor should never ignore a company’s debt position when buying a stock since debt is a strong indicator of a company’s financial health and future.

3. Earnings can be manipulated easily: Clever accountants have a million and one ways to make companies look more attractive. This can involve changing depreciation schedules, using different inventory management strategies, and including non-recurring gains. These strategies are not limited to corrupt organizations, as firms are given some legal flexibility in how they choose to report their earnings. As a result, because companies have an incentive to make earnings look as attractive as possible, P/E ratios can be presented as being artificially low.

4. Growth companies trade at higher P/E ratios: Since P/E ratios represent not only a company’s current financial situation but also it’s future growth potential, growth stocks trade at significantly higher P/E multiples than value companies. Thus, without understanding what type of company you are considering as an investment, you might carelessly overlook some valuable growth companies simply because of their P/E ratios. In fact, some of the biggest winners of all time have been companies with high P/E ratios. According to Investors Business Daily, in a recent analysis, the top 95 companies had an average P/E ratio of 39 before gaining momentum and reaching an average P/E ratio of 87 at their peak. Yet according to the models of most investors who rely solely on P/E ratios, all of these companies would have been ruled out as being overpriced.

5. False assumption that low P/E ratios represent cheap trading opportunities: Many investors assume that a company trading at a P/E ratio must represent great value. As we know, because of many of the factors stated above, low P/E ratios do not necessarily make the best investments. For example, Suzlon was a company that was trading at single digit P/E ratios before it crashed.

P/E ratios are a valuable tool for investors, but they are not sufficient to identify the feasibility of an investment unless used in combination with other metrics and company characteristics.

Regardless of your opinion on the P/E ratio, you should always examine other ratios as well before buying a stock. These metrics, which help investors evaluate other aspects of a company, include Enterprise Value/EBITDA, Enterprise Value/EBIT, Enterprise Value/Revenue, Price/Cash Flow and Price/Book Ratio.

Final Word

The P/E ratio is a great start to understanding a company’s value proposition as a potential investment. With that said, don’t forget that there are many other ratios and factors to consider other than the P/E ratio. The P/E ratio is just one piece of the puzzle. And if you only take one lesson from this post, remember this nugget of information: the price of a stock is not an indicator to identify value of it!

Also Read: 4 Hidden Gems of 2011 which doubled investors money in one year.

Tuesday, July 12, 2011

Why PE Ratio is Important in Evaluating Stocks?

The P/E is the most popular way to compare the relative value of stocks based on earnings because you calculate it by taking the current price of the stock and divide it by the Earnings Per Share (EPS). This tells you whether a stock’s price is high or low relative to its earnings.
Some investors may consider a company with a high P/E overpriced and they may be correct. A high P/E may be a signal that traders have pushed a stock’s price beyond the point where any reasonable near term growth is probable.
However, a high P/E may also be a strong vote of confidence that the company still has strong growth prospects in the future, which should mean an even higher stock price.
Because the market is usually more concerned about the future than the present, it is always looking for some way to project out. Another ratio you can use will help you look at future earnings growth is called the PEG ratio. The PEG factors in projected earnings growth rates to the P/E for another number to remember.
You calculate the PEG by taking the P/E and dividing it by the projected growth in earnings.
PEG = P/E / (projected growth in earnings)
For example, a stock with a P/E of 30 and projected earning growth next year of 15% would have a PEG of 2 (30 / 15 = 2).
What does the “2” mean? Like all ratios, it simply shows you a relationship. In this case, the lower the number the less you pay for each unit of future earnings growth. So even a stock with a high P/E, but high projected earning growth may be a good value.
  
Looking at the opposite situation; a low P/E stock with low or no projected earnings growth, you see that what looks like a value may not work out that way. For example, a stock with a P/E of 8 and flat earnings growth equals a PEG of 8. This could prove to be an expensive investment.
  
A few important things to remember about PEG: 
  • It is about year-to-year earnings growth
  • It relies on projections, which may not always be accurate