Saturday, July 16, 2016

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.

Friday, July 15, 2016

If you buy things you do not need, soon you will have to sell things you need

Besides being one of the world’s richest persons, Warren Buffett is also one of the greatest teachers. He leads a simple life and advises others to do the same. He says, “If you buy things you do not need, soon you will have to sell things you need”. How true and what golden words of wisdom!

My Teenage Foolish Advice to Buy Things You Do Not Need

I also used to debate a lot on matters of science, economics and politics. In youthful rashness often stupidly I used to lead the debates into heated arguments. I still vividly remember the fiery disagreement I had with my eldest brother one day. In the quarrel, I vehemently contended that during times of high inflation it was better to blow the money instead of saving. When I reflect on it today what a stupid and absurd argument it was.

Of course, I was not completely wrong; it was useless to save when the return was lower than inflation.  But the solution I suggested of blowing away the money was not right.  Splurging on unwanted things simply because inflation was high cannot be justified. We should explore alternate avenues. of investment that yield returns greater than inflation; history proves that prudent investment in shares, or index mutual funds, coupled with patiently lying invested for a few decades, will certainly yield spectacular results.

Practising Austerity Not Difficult

It is not very difficult to practice austerity once you realize how compounding can produce spectacular results from tint investments. Even the few dollars you spend on a pizza can buy you a couple of stocks of a wonderful company. If the cost of a pizza can produce remarkable results, imagine what the cost of an expensive holiday can do?


Sadly, We Don't Heed the Advice

Unfortunately, we realise simple but solemn truths only late in life, by this time it might already be too late. And the realisation useless. Advertisers are marketers are ever trying to make spend on unwanted luxuries.

Recently I saw a tempting advertisement for a luxury, one-way flight ticket costing US$ 38,000 from New York to Mumbai. They provide you with a residence,  comprising a bedroom, lounge and a shower room.


Don't buy things you do not need























There are many such alluring offers, urging us to splurge.

Conclusion

Sadly, every day I see young and bright youth blowing away their handsome salaries on unwanted luxuries like expensive clothes, mobile phones, holidays and automobiles as if there is no tomorrow.
If only we could heed Buffett’s advice, lead simple lives and invest judiciously, we can not merely achieve financial freedom but can accumulate inexhaustible wealth.

If you don’t and continue in wayward ways and buy things you do not need soon you may have to sell things you need.