‘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.