Why P/E ratio doesn't do justice?
Probably the first ratio that a lot of investors look at is the P/E ratio of a stock to judge whether the stock is under-valued or over-valued.
What is P/E ratio?
A price to earnings ratio is a very simple valuation metric; it’s the price of a stock divided by the earnings of the company per share of stock. P/E ratio is a comparative ratio, i.e. you compare P/E ratios of different stocks of the same industry. Change the industry and the average P/E ratio changes.
Example: A stock that has a Market Price of Rs.1000/- and has Earnings (EPS) of Rs.500/- then it has a P/E ratio of 2x.
Why I do not like P/E Ratio?
I call P/E ratio a very dumb ratio because a P/E ratio never takes into account a company's fundamentals. It just tells an onlooker that a particular stock is cheap or expensive based on the current stock price. It doesn't tell you WHY the stock price is expensive or cheap.
The data that we see is 'Trailing P/E ratio' i.e. P/E ratio on the basis of last 12 months of earnings. If you find 'Forward P/E ratio' mentioned somewhere, it should raise further doubts, as to why are the given projections taken in the first place and on what basis? As long as future remains unpredictable, I prefer Trailing P/E ratio as it eliminates human assumptions and is therefore, more objective.
Coming to why I do not feel that a P/E ratio can ever justify a stock's return or potential return, I would like to give a few examples.
Example 1 (Nestle vs ITC)
Nestle is a very expensive stock on P/E ratio and ITC is a reasonable stock. In this chart, Nestle is the Blue line and ITC is the Purple Line. The market for multiple reasons gave up on ITC and even though ITC has huge earnings, the gap between ITC and Nestle keeps on widening. However, the market has been very smart that the P/E ratio never falls to Bank FD Rates. This way, the stock has been cheap for years running and the stock has still not delivered. Nestle on the other hand has been in a bull run of its own even though it trades at more than 80x earnings!
Now the discussion around the fundamentals and the inherent reason of why a company has such a premium can be discussed in a later blog post. The point that I am trying to make here is that a company which trades at a low P/E ratio won't necessarily outperform or deliver greater returns in the future.
(Charts as on 29/05/20, P/E ratio of Nestle: 83.25, P/E ratio of ITC: 16.1)
Example 2 (Dr. La PathLabs vs Thyrocare Technologies)
The Blue line is Dr. Lal PathLabs whereas the Purple line is Thyrocare Technologies. Again in this example we can see how a low P/E Ratio stock doesn't outperform. Both these stocks have recently listed and are in Diagnostic Business. One has clearly outperformed, again the reasons are plenty but that is not the scope of this post. This should show us as to why P/E ratio is not a successful metric in judging a stock's fundamentals.
Then where should one focus when it comes to P/E ratios?
The clear focus of anyone analysing a company should be to find out why one company trades at a premium valuation to another. Once you focus on this, you will know why markets will always allocate more premium to certain companies. Factors can be plenty, maybe it is the promoter quality, brand recall, distribution network, patents held by the company, franchise, etc. Knowing this reason is very important.
I do not use P/E ratio and do not focus on it. But if a company that I am picking up, has a very expensive valuation (in respect to its peers), I will try to figure out why the market is ready to give this company such a valuation and not the others. Once that is figured out, the P/E ratio again becomes insignificant for me.
Therefore, even though P/E ratio is widely taught and extensively debated about, I feel no reason for the same and have learnt to limit its usage to find a moat in the businesses that I pick.