LOW P/E OR HIGH P/E: WHAT IS BETTER?

With expensive stocks getting more expensive, there exists considerable confusion in an investor’s mind whether to construct a portfolio with low p/e stocks which, traditionally, is a preferred strategy to beat markets or include more high p/e stocks in the portfolio. Geyatee Deshpande shares her unique perspective on a topic that concerns a majority of investors.

“How can a stock trading at 1,000 + p/e multiple be one of the big gainers in 2019? I am talking about 63 Moons Technologies Ltd. here. It has generated returns in excess of 42 per cent in 2019 alone and the price multiple it is trading at is unbelievable. Isn’t it an expensive stock– even for a long-term investment?” asks an investor to the expert speaker in an investor awareness programme. The investor is obviously a little confused on how to interpret the p/e ratios and is finding it difficult to digest the fact that a stock with such a high p/e ratio can not only deliver positive returns but also do better than a majority of low p/e stocks that are supposed to do well – this being the perception.

Indeed, the year 2019 saw lots of high p/e stocks outperforming the market and especially those that reflected low p/e stocks. If that is the case, should the investors not adjust to the new reality (upward shift) on p/e multiples? A p/e ratio of 18 may sound normal today but during 1990s the same p/e must have looked extremely expensive. As time passes, the way market prices of the stocks change, there is always a possibility of a shift in the p/e ratios – mostly upwards. To get to the bottom of the story we need to first understand what influences p/e ratio and how best can a market-beating portfolio be constructed using p/e multiples.

What Influences P/E Multiple?

Price to earning ratio is simply a ratio of market price per share to the earnings per share of the concerned company. Basically, the following types of stocks have shown tendencies to reflect lower p/e ratios:

Those stocks which have a lower expected growth in earnings built in will always tend to reflect low p/e! In case of stocks where the earning has been volatile and is expected to be volatile , the p/e multiple will always be low.

Those stocks reflecting higher riskiness in business and operating with higher leverage i.e. higher D/E ratio will always tend to reflect lower p/e multiple.

If we consider the type of stocks that have tendencies to reflect lower p/e multiple, there is always a risk of buying those stocks where growth is absent and the prospects look dim. There is always a risk of entering a poor quality stock if one makes the buying decision simply based upon the low p/e multiples.

Conditions or Filters for Buying Low P/E Stocks

Buying stocks with low p/e has proven to be a profitable strategy, albeit in the long term. However, there are certain precautions any investor has to take before he or she simply buys stocks based on p/e valuation. We just saw that the stocks that reflect lower expected growth have volatile earnings, lower historical earnings growth, lower RoE and lower cash flows with a tendency to reflect lower p/e. What long-term investors can do is put filters such as those outlined below:

☛ Include only those stocks where the earnings have grown by at least 8 to 10 per cent year-on-year for past five years.
☛ Only those stocks with RoE greater than 12 to be considered.
☛ Only those stocks whose expected growth in earnings is in the range of 8 to 10 per cent can be considered for further research. Once such filters are placed, investors at least will not be exposed to poor quality stocks that reflect low p/e ratios. 

"Investors have to understand that it is ultimately the fundamentals that drive the p/e multiples. It is the cash flows, debt to equity ratio and the return on equity that drives the p/e multiples. It is but natural that those companies with higher cash flows, lower debt to equity and higher return on equity will reflect a higher p/e multiple.

A quality stock will usually showcase higher return on equity, higher cash flows and lower leverage which may lead to higher expected growth in profits. Thus, the market will be willing to pay a premium for such quality stocks and hence the p/e multiple will always be higher for such stocks and there will always be demand for quality stocks which in turn will push the p/e higher."

Sensex P/E Overtimes

From the table below we can see that the average price-earnings multiple is steadily inching up for the Sensex. In a period of less than than 15 years the average price-earnings multiple has inched up by almost 30 per cent. Investors will have to adjust to the new normal when it comes to priceearnings multiples! 

P/E & PEG Ratio
Most investors these days use PEG ratio instead of the plain vanilla p/e ratio. The biggest advantage PEG ratio has over the p/e ratio is that the PEG ratio factors in for the growth in earning. Let's say for example the p/e ratio for HDFC Bank is 18 and that of ICICI Bank is also 18. How does one choose which bank to invest in when the p/e is same for both the banks. In such cases the answer can be found in PEG ratio.

In the above example , lets assume the earnings growth expected for HDFC Bank is 20 per cent while that for ICICI Bank is 25 per cent , then ICICI bank is relatively undervalued and should be preferred for investment.

In case a stock has a high PE and is operating in high growth industry, PEG will level the playing field with a low PE stocks in a slower growth industry.

Thus PEG ratio can help solve the growth dilemma for the investors while discounting the p/e ratio for making investment decision. PEG ratio can help compare high p/e stocks with low p/e stocks.

Conclusion

Finding a bargain using p/e ratio data is not as easy as it sounds. One has to actually study the fundamentals in depth before making an investment decision based on p/e ratio. The price earnings multiple is useless unless one studies the expected growth, historical growth, RoE and cash flows. Investors must remember that the objective is to find undervalued stocks and not low p/e stocks. High p/e stocks could also be undervalued.

Investors can check whether the p/e ratio for the stock is less than the median for the industry. It is essential that any investor hunting for low p/e stock has to decide whether the trade-off of a lower p/e ratio for lower growth works in his favour. The understanding of such trade-off often comes after spending much time in the markets and focusing on the fundamentals of a company. Ultimately, what investors should aim for is a portfolio of stocks with low pe ratios, high quality earnings (growth) and lower risks. The risk level of any stock can be ascertained by studying the beta measure of the stock or even the standard deviation.

If investing in high pe ratio stocks is considered risky, a strategy of investing in stocks just based upon their low price-earnings ratios can be dangerous. Investors should study stocks on their merits and fundamentals and should be willing to pay higher for quality growth instead of avoiding stocks only because they are trading at a high price-earning multiple!