Understanding earnings quality and PE ratios can help you find value deals in this market.
Every market situation has its key phrases. In the present market conditions, experts are often using phrases like “there are great value deals available” and “look at the quality of earnings”. While every financial guru worth his salt gives such advice, what does this really mean and how does it help you become a better investor, is the real question.
Ritika Mankar, economist, Ambit, says: “The most important parameters looked at when building our ideal portfolio is, superior quality of earnings, inflation immune sectors and good valuations given the projected earnings.”
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Joel Greenblatt in his book, The little book that beats the market, formed a ranking system through which he would pick stocks. There were two fundamental values, return on capital invested (ROIC), the higher the better, and price-to-earnings (P/E), the lower the better, on which he ranked companies. A combination of these two rankings helped him arrive at a list of stocks that proved to generate higher returns over a period of time.
Price to earnings (P/E) is very important when it comes to the bottom-up stock picking approach. Vaibhav Agarwal, VP Research, Angel, says: “The Sensex target P/E for FY13 is 14, and every company has its own fair P/E in comparison. In fundamental analysis, one looks at the future outlook and evaluates the company on the basis of numerical factors like growth and profitability. The higher the ROIC and the higher the growth potential of the firm, the higher is the P/E.”
For example, in the banking sector, P/E ratios vary greatly and understanding why one is high and another low will help you spot value deals. Public sector banks like SBI are trading at a P/E of 12, while Punjab National Bank is at a P/E of 6.6. Mid-cap banks are trading at a P/E of below five, while the industry average of the large-cap public sector banks is a P/E of 10. This, in comparison to the Sensex P/E of 15, which clearly indicates that public banking sector stocks are down valuation-wise and can, hence, provide a good investment opportunity. Private banks like ICICI are trading at a PE of above 40, while HDFC is at 26 and Axis at 12.
“A low PE indicates low confidence, while a higher PE indicates the market is willing to pay more for the earnings of the company. This makes the stocks expensive. In the banking sector, private banks have a higher P/E due to less non-performing asset (NPA) concerns, government intervention, and so, investors are willing to pay more” says Alex Mathew, head of Research, Geojit.
On the other hand, FMCG stocks are trading at the 30-35 P/E range, with HUL at a PE of 33 and ITC at a PE of 28. Similarly in the pharma sector, GlaxoSmithKline trading at a P/E of 20 and Pfizer between 15-20 shows that people are willing to pay more for these stocks.
“People are willing to pay more for these sectors as they are defensive. In such times, people will always pay more for defensive stocks. Globally, rating agencies have downgraded banks across the world, leaving the sector volatile. However, P/E-wise, PSU banks are very cheap in comparison to private banks, pharmaceuticals and FMCG stocks. While P/E is a good way of evaluating stocks, looking at the quality of earnings to see if a lower P/E is indeed a good opportunity and not reflections of bad performance is important,” adds Mathew.
If the company financial statements show that earnings are arising out of high cash flow and conservative accounting policies, the earnings are considered good, while if the earnings come from other sources like inflation, one-time sale of assets or aggressive accounting, the earnings are considered to be of bad quality. Good quality earnings indicate the firm is generating cash flow from its core business and such earnings are considered high on sustainability and low on risk. The quality of earnings is more important when dealing with overvalued companies who show strong earnings due to accounting principles used, but have a low cash flow from operations.
