What is 'Price to Earnings Ratio'? - Presentation

What is price to-earnings ratio? from Pilk Anand

What Is Price To Earnings Ratio?

‘Price to Earnings Ratio’ or ‘PE Ratio’ or ‘PE Multiple’ forms the bedrock of all value investing, as the ‘Value’ derived from stock purchase depends on tow crucial factors, of which PE is one. Following paragraphs describe what it is, its importance, how to use, and the limitations.  How to calculate the ratio is dealt with in separate article, under the ‘How To’ series.

As the name suggests, there are two components to the metric, price and earnings.  ‘Price” is what you have to pay to purchase the stock or share in the market, of a certain company, and ‘Earnings’ are the total earnings or net profits after tax, earned by the company, brought down to individual share level, obtained by dividing the total net profits by total number of equity shares, and technically termed, ‘Earnings Per Share’ or ‘EPS’.

Lets learn how to use the ratio. The number recommended by Benjamin Graham, the doyen of value investing, is ‘Not Exceeding Ten’.  The commandment is, ‘Do Not Pay More Than Ten Times the EPS’.  What is the rationale behind the sanctity of this number?  I have not seen any explanation in Graham’s books, but in my opinion is any stock, worth its salt, must earn a minimum ten percent and the investment must be earned back within ten years.

A second and equally important caveat is attached to the calculation of PE.  It is not sufficient that the PE Ratio of a company is less than ten in a single year; the company should demonstrate sustainable profits in future through its proven track record; the PE multiple should be less than ten when you divide the current market price or CMP by the ‘Average EPS’ at least in the last five years.

‘PE Ratio’ should not be negative.  This is the first limitation of the relation. Negative results are obtainable in any ratio only when either the numerator or denominator is negative. Since the number of shares of a company cannot be a negative figure, it only means that the denominator, EPS is the culprit, which ultimately means that the company has suffered loss.  In value investing, a blanket ban prevails on purchasing all loss making companies, even if it is in a single, rare year.  An exception is rarely granted; permitted only if there are extremely compelling circumstance.

The second limitation is that while it is desirable to buy shares of wonderful companies at a PE Ratio below ten, it extremely difficult to buy at that multiple, as they simply are not available in the market at that price, even after a great market crash like post Lehman Brothers! For example, shares of Gillette India Ltd., are today, middle of July, 2016, are available at a PE multiple of a whopping 64.61. In my own experience in share markets exceeding over fifteen years, it would not have been below 25, as against the recommended ten. So, what is the solution? My guru, Warren Buffett too admits to this reality, and says that he sometimes makes exceptions to the general rule, and accepts to a fair price.  It is impossible to define an exceptional maximum number; it entirely depends on the merits of the situation; judgment of the value investor, which can only develop over many years of study and practice.

It is Far Better to Buy A Wonderful Company at a Fair Price than a Fair Company at Wonderful Price

When Warren Buffett said, “It is far better to buy a wonderful company at a fair price than a fair company at wonderful price”, he is clearly stating that the investor should only buy excellent companies’ shares and pay a reasonable price for them. 

So there are two distinct caveats in his advice – Excellent Company and Reasonable Price.

What is an Excellent Company?  Buffett has given ample clarity.  It should not only have had a long and successful existence, but should also be capable of thriving for a long time in future, and its products or business should be such that people will need them for foreseeable future. Mere longevity is insufficient, the business should have been profitable for a long time into the future and should be capable of generating profits and “”Free Cash Flows” well into foreseeable future.  The company should stick to its core business, never or insignificantly borrow, and shall possess the culture of rewarding the shareholders with handsome, regular and uninterrupted dividends.  Let us take the example of Gillette.   It produces excellent razors.  One can never foresee a replacement for razors or people not needing a shave, thus endowing permanence to the company’s business.  Thus, Gillette satisfies all the qualifications of an “Excellent Company”.

Now let us examine the price element.  We should not pay a fancy or unrealistic price.  If we do so the “Return On Investment” or “ROI” for the money we have invested will be poor.  However, this is easier said than done.  Today, on 7^th July 2016, Gillette India Ltd. Shares are trading at an unrealistic, “Price-to-Earnings” or “PE” multiple of 63.76 as against the acceptable 10, and a “Price-to-Book Value” or “P2BV” of 20.44 as against the recommended 1.5.  Under such impractical market conditions what can we do? 

No reason to despair.  One can always find a handful of excellent companies whom the market is disfavoring at that time.  We should invest in those companies.  We should also make a list of the other excellent companies but which are expensive.  We should revisit them during large market crashes like the post “Lehman Brothers”.  My own experience shows that even during such extremely depressing times, companies like Gillette will not be available at the idealistic PE of 10 and P2BV of 1.5.  You may find them at a PE of 25 and a P2BV of five to ten, at that time you should BUY.  If you hesitate, you will never get the opportunity to own such companies.  I had vacillated, and let me admit, I do not own any of these good companies.

On the other hand, when people buy shares based on “Tips”, usually given by brokers and the So-Called-Experts, they end up doing the opposite of what Warren Buffett has warned, Buying Fair Companies At Wonderful Price, instead of Wonderful companies At Fair Price.