ON January 5th, 2009, after the article titled, "Three steps to successful investment in Bangladesh stock markets", was carried by this paper, this scribe got so many e-mails regarding P/E ratio and its reliability in taking investment decision. Most of the questions were "what is the best P/E ratio?" to take investment decision in Dhaka Stock Exchange (DSE). This writer was surprised to see investors' "fondness" to P/E rather than firm's financial statements or other factors that define firm's business capability or prospect. In fact, financial journalists and academicians in Bangladesh always depict that price-earnings multiple is everything one needs to know to invest in the share market. When the present writer was in a position to invest in the Ashland University's endowment fund, he was trained to focus on the fundamental values of a company rather than on P/E matrix or on any other particular ratio. Anyway, today he would like to share some thoughts on P/E ratio for the beginners in Dhaka Stock Exchange.
P/E ratio is a valuation ratio of a firm's current share price compared to its per-share earnings. For example, if a company's share is currently trading at taka 50 a share and earnings over the last 12 months were taka 2 per share, the P/E ratio for the stock would be 25 (tk.50/tk.2). Theoretically, a share's P/E matrix tells us how much an investor is willing to pay per dollar of earnings. In other words, a P/E ratio of 25 suggests that investors in the stock are willing to pay Tk. 25 for every Tk.1 of earnings that the firm generates. However, this is a far too simplistic way of explaining the P/E ratio. Why? There is another interpretation of P/E ratio: the P/E ratio is as a reflection of the market's optimism concerning a company's growth prospects. If a company has a P/E higher than the market or industry average, this means that the market is expecting big things in the near future. Similarly, a low P/E ratio does not necessarily mean that a company is undervalued. Rather, it could mean that the market believes the company is headed for trouble.
However, share analysts in the USA reports two P/E ratios: Trailing Price-Earnings ratio and Forward Price-Earnings ratio. Trailing Price-To-Earnings ratio (Trailing P/E) is calculated by taking the current share price and dividing it by the trailing earnings per share for the past 12 months. So, this Trailing P/E ratio is a historic measure. It tells us how long it would take to make back your initial investment in the company, if it keeps generating the same earnings that it did in the past year, but there's certainly no guarantee that this will happen. How will you calculate P/E multiple when a firm had a bad year, i.e. suffered loss? For example, dividing a share price of Tk. 200 by a "current" EPS number of negative Tk. 20 gives a meaningless result of -10. This is why analysts in the USA also reports forward P/E ratio which is calculated by taking the current stock price and dividing it by earnings estimates for the next year. So, forward P/E ratio is helpful in such a situation where a company is emerging from a period of losses. In fact, forward P/E is more important than trailing P/E. After all, it is the future that counts. You are paying what the company will do in the future rather than what the company did in the past.
Does the difference in P/E ratios alone make one company a better investment target than the other? Definitely not. Yet investors tend to rely excessively on this one multiple in determining an investment's attractiveness. So, why shouldn't we use P/E ratio alone (in fact, this scribe does not even put any weight on it!)? Since P/E is suffering following serious flaws, if you use P/E alone, you will be surely putting your life-time savings in huge risk:
First of all, Price-Earnings multiple always overlooks a firm's growth prospect. Low P/E ratio does not necessarily mean the stock is undervalued. For example, company X with a P/E ratio of 15 and 0 per cent earnings growth may not look as appealing as company Y with a P/E ratio of 20 and 25 per cent earnings growth. The reason is if both firms' share prices remain the same, after 3 years, P/E ratio of company Y will decrease to 10.3 while X will still have a P/E ratio of 15. So, along with P/E ratio, investors also need to take into accounts future growth rate of a company.
In addition, earnings per share (EPS) is an accounting figure that can always be twisted, prodded and squeezed into various numbers depending on how you do the math. For instance, creative accounting decisions, such as changing depreciation schedules or including non-recurring gains at certain points in time, can manipulate this figure easily. Because of the weak check and balance system in Bangladesh, investors should be aware of companies' frauds practice in accounting.
Moreover, "Price per Share" in P/E ratio only refers to the equity price of a business; it doesn't consider debt. That's perfect for companies without debt, like Google, but it's meaningless when there is debt involved. For instance, a business with a market cap of Taka 400 million, with Taka 100 million of net debt on the balance sheet, has an economic value of taka 500 million. If this company earns taka 50 million in profit in a given year, the P/E ratio would be 8; but in reality, investors should see it as 10. Also, companies with higher net cash in their balance sheet usually get higher P/E valuation.
Furthermore, numerator in the P/E ratio, i.e., price of the share, also ignores any appropriate adjustments on the balance sheet that would change the value of the company. For instance, land value is usually understated on the balance sheets, a trend the P/E ratio ignores. However, P/E ratio takes into account one-time event such as restructuring cost or downward adjustments in goodwill. When that happens, the denominator in P/E ratio, i.e., earnings per share will appear low. As a result, this event overstates P/E ratio.
Additionally, P/E ratio also ignores interest rate risk. When we invert P/E ratio, we get E/P ratio, i.e., the yield on our investment. A stock with P/E of 10 is yielding 10 per cent. Stock with P/E of 20 is yielding 5.0 per cent, and so forth. If interest rate rises to 6.0 per cent, ceteris paribus, then stocks that are trading at P/E of 20 will surely become overvalued. Besides, P/E ratios tend to be lower during times of high inflation because the market sees earnings as artificially distorted upwards.
So, this scribe's recommendation to valued readers of this paper is to consider few factors before using P/E ratio in their investment decisions. First of all, take into account a firm's growth prospect, i.e., how fast has the company been growing in the past, and are these rates expected to increase, or at least continue, in the future? Second, it is wiser to calculate the P/E using projected EPS, i.e., use Forward Price-Earnings ratio. If projected growth rates don't justify the P/E, then a stock might be overpriced. Third, P/E is only useful to compare companies if they are in the same industry or in the same sector. For example, a bank's P/E ratio should only be compared with other banks not with a utility, textile, food or an IT company. Comparing a pharmaceutical company to a utility is useless. You should only compare one company to others in the same industry, or to the industry average.
While the P/E ratio is a very useful resource, its often-ignored limitations can sometimes trap clever investors off guard. Use P/E carefully and prudently, and you'll be a lot less likely to fall into any pricey situations. The moral of the story here is not to use P/E ratio alone to take your investment decision in the stock market. Don't take any buy or sell decision based on price-earnings ratio. While the P/E ratio is one part of the puzzle, it's definitely not a crystal ball. Stock analysis demand a great deal more than understanding few simple ratios.
*This article was published on the daily Financial Express in Bangladesh on January 20, 2009.
No comments:
Post a Comment