Share Selection Using PE Multiple

The PE Multiple (Price to Earnings ratio) has been one of the most popular approach to equity valuation. PE ratio of a company is calculated by dividing the current price of the share with its earnings per share. Thus PE ratio indicates a number which is unit of company earnings that an investor is willing to pay and hence it should be used to compare if stock is cheap or expensive verses other stocks in the same industry.

A lot can be said about the ratio but a general understanding regarding PE ratio is that a growing company would have a higher ratio as compared to low growth company and hence PE ratio is considered as a proxy to the growth rate of a firm. If we have to make a comparison between two stocks lets name them as company XYZ which is trading at a price of Rs.10 with PE multiple of 30 and company ABC which is trading at Rs. 1,000 with PE multiple 5; by looking at the price levels we can be misguided in our conclusion, but when we compare PE of these two stocks we will reach the correct conclusion that company ABC is cheaper. PE multiple is a simple way of comparing stocks and identifying which is cheaper if all other financial parameters are similar.

Value investing and growth investing are two different schools of thoughts. Adam Smith, Ricardo, Aristotle- tried to define value – but unfortunately there is no universally accepted definition of value. When it comes to exploring value of stocks the definition and methods of arriving at value are debatable.

Value investing is understood as investing in stock which has attributes like low price earnings ratio, low price to book value ratio, or a high dividend yield ratio.  All such characteristics are no guarantee that the investment decision would be value accretive but these ratios can be a strong indicator of value and shares which qualify on these ratios should be analyzed further on other financial parameters. Business growth has a positive impact on value and is not captured by any of these ratios. Similarly intangibles like quality of management, accounting quality, employee friendliness are not considered when we base our decision only on few standalone ratios. However since PE is widely used when we are comparing companies across industry or on an overall bases, in this article we will focus on selecting stocks using a PE ratio technique and analyze results of the last five years to see if this strategy works.

For analysis we select all non-financial listed companies with continuous financial history of last five years and applied filter to select companies with positive PE ratio (thus eliminating all loss making companies). Then we selected companies with market capitalization of over 10,000 Crore as on 15 February between 2012-2017 (this was done to eliminate small companies with poor liquidity and marketability). We had 222 companies which qualified on all the parameters.

We calculated year on year return for each of these 222 companies and divided these companies in 6 portfolios. The average and median values of stock returns within each of these portfolios were calculated. Since a low PE stock in 2012 can become a high PE stock the next year we assumed a holding period of one year. And so every year the portfolio may have new set of companies.

Data in  table-1 (which has average returns across all six portfolios), indicates that the portfolio which has shares of companies with PE ratios between 0-10 has performed better that the S&P BSE Sensex Return across all the years and average returns in year 2015-16 and 2016-17 were maximum as compared to all other portfolios. This finding is also supported in table-2 which has median returns. The worst portfolio across all the years is the one with shares of companies with PE ratio greater than 100.

From this analysis we can conclude that companies with low PE as compared to their Industry PE have a better chance to appreciate as these are relatively cheaper. While analyzing companies with low PE, if retail investors can also look at growth rate of sales and Return on Equity (ROE), it would help them in identifying value stocks.