A 10 PE or a 100 PE stock—what should you opt for?

But what is it that truly drives stock prices?

The popular quote ‘stock prices are slaves to earnings’ suggests earnings drive stock prices in the long term. It’s hard to believe that in this day and age. But this is an incontrovertible fact.

That said, are earnings driving this bull market?

Kind of. There is no doubt that certain industries have done phenomenally well in recent years. And it’s possible that this performance, benefiting from the tailwind of India’s economic growth, could continue for some more years – hiccups aside.

However, other industries have disappointed. Or rather, their earnings lag expectations by a huge margin, with little sign of the gap closing in the medium term.

In fact, in the recently concluded April-June earnings season, the Nifty PAT growth was lowest since June 2020, Motilal Oswal said. (Of course, India’s general election ran from April to June, likely affecting corporate earnings).

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What else drives stock prices? The “valuation" factor. The price-to-earnings (PE) ratio, in particular. There are other metrics as well, such as the price-to-book value, enterprise value/ebitda, and market cap/sales, but PE is perhaps the most popular of the valuation ratios.

In the recent bull run, the high valuation of stocks has been a big concern. Let’s dig into this a bit.

Smallcap and midcap indices have risen by 3-4 times versus the large-cap index’s 2.25 times growth in the past five years. The jump has been quite sharp over the past year or so.

Take a look at what happened to valuations, as measured by the PE ratio, over the past year. The BSE Smallcap Index, which hit a low of about 27, is now trading at a PE of just under 35—which by any measure is quite pricey.

The BSE Midcap index has seen PE multiples expand from 23x to over 32x.

And finally the BSE Sensex, which include bigger companies, is presently trading at a PE of just under 24.

Smallcap and midcap stocks are considered expensive due to this quick run-up, whereas large-cap stocks are relatively inexpensive.

This is to be expected in a risk-on mode, when one is tempted to ignore concerns about the long-term sustainability of businesses or, for that matter, even the quality of corporate governance.

But even among the largecaps, the PE multiples vary widely – from less than 10x to well above 100x.

To illustrate the point, here is a simple screener run on Tijori Finance for companies with market cap higher than ₹50,000 crore. The chart on the left lists companies with PE multiples under 10x and the one on the right lists those with PE multiples above 100x.

Note: Banks and non-banking financial companies are benchmarked primarily with price-to-book ratios. We have included them here anyway to highlight a larger point about valuations.

Now, by all means, a low PE alone doesn’t necessarily imply good value. Several companies remain cheap for long and value traps, i.e., they are cheap for a genuine reason and not because the market has ignored them. Several others that are apparently expensive continue to grow their earnings and perform well. The point is to look for margin of safety through a lower PE.

So what is it that determines the PE multiple for a stock?

Some of the factors are:

1. The industry: Is it in a new industry such as green energy or electronics manufacturing, or an old one like paper or coal?

2. Growth prospects: A company’s growth prospects depend on several factors, including its track record, future projections, order book and capital expenditure.

3. Quality of earnings: Have the earnings been consistent? Are they cyclical? Is there any one-off?

4. Corporate governance: Are the reported numbers reliable? Does the company have a mischievous history? Are its accounting policies conservative? Does its cash flow reflect its operating profit?

Electronics manufacturers such as Dixon Technologies Ltd and Voltas Ltd are in a sunrise industry and are likely to see a consistent and secular growth in demand.

New-age firms and software platforms such as Zomato Ltd, PB Fintech (Policybazaar), and Info Edge (Naukri) have the potential to grow their earnings exponentially. Most of their costs such as software and brand-building have already been incurred and they can create new revenue streams through their platform.

Historically, fast-growth companies such as Trent and Avenue Supermarts command a premium because of their rapid and consistent growth.

Consistency in earnings can simply be determined by year-on-year growth in sales, profit and operating free cash flows over 5-10 years. A company with a strong and consistent track record will be valued higher that those with inconsistent or cyclical ones.

On the other hand, one-time events such as general elections can affect the earnings for a quarter due to the uncertainties they bring.

Overall, several factors combine to determine a company’s price-to-earnings ratio. One has to dissect the factors that improve a company’s fundamentals over the long term rather than those that can lead to short-term popularity.

As the legendary financial analyst Benjamin Graham said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine."

An investor needs to determine if a company’s current PE multiple reflects a voting machine or a weighing machine.

While some PE multiple expansions can be justified, it’s clear from what has been explained above that companies with a PE of less 10 companies could be expensive, while some 100-PE companies could be cheap. And vice versa. It all depends on future prospects.

The debate over growth and value is perennial, and quite unnecessary.

Warren Buffett got it right years ago: 

“Whether appropriate or not, the term ‘value investing’ is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics—a high ratio of price to book value, a high price-earnings ratio, a low dividend yield—are in no way inconsistent with a ‘value’ purchase." (Berkshire Hathaway 1992 Annual Report/Nomad Partnership letters)

Either way, it’s important to have a margin of safety when investing in a company. If you pick the right stock, with enough margin of safety, you will perhaps have made a fantastic start.

If, however, you are the punting type, it may help to remember another quote by Warren Buffett:

“Only when the tide goes out do you discover who’d been swimming naked."

And then, ask yourself: Are you willing to take the risk of holding expensive stocks when the music stops?

Note: The purpose of this Profit Pulse article is only to share interesting charts, data points and thought-provoking opinions. It is NOT a recommendation. If you wish to consider an investment, consult your adviser. This article is strictly for educational purposes only.

Ruchit Shah has been researching and investing in the Indian markets for the past four years. He is not a Sebi-registered investment adviser.

Disclosure: The writer or his dependants may or may not hold the stocks/commodities/any other asset discussed in this article.