In a depressed market, investors look for hope from different ratios to identify stocks with a good potential. A look at one such number - the price to earnings ratio.
When markets are on the rise, investment are made by using a rather simple formula - just buy stocks or sectors that are riding the boom. For instance, in the last rally, stocks of the realty and power sectors were in vogue.
| LOW P/E STOCKS IN BSE 100 | |
| AS ON 22 AUG 2008 | P/E RATIO |
| Union Bank (I) | 4.66 |
| Hindalco Inds. | 5.35 |
| H D I L | 5.49 |
| Bank of India | 5.87 |
| Financial Tech. | 6.03 |
| Sesa Goa | 6.18 |
| India Cements | 6.27 |
| Bank of Baroda | 6.29 |
| Pun. Natl. Bank | 6.59 |
| Tata Chemicals | 7.66 |
On the contrary, things are completely different when markets are slipping down. And while experts use that famous line - 'buy in a falling market' - it is almost impossible to put your finger on one sector or stock as the right one. Of course, there are defensive sectors like pharmaceutical and fast moving consumer goods (FMCG) that are supposed to do better. But the bottom line is that life does become a little more difficult for the investor.
While 'bottom fishing' sounds like a great line, identifying the right stocks is the greatest challenge. Various ratios such as dividend-yield, price-earning to growth, price to book value, price to earnings and many others that help you to identify stocks. Here we discuss one such ratio - low price earning (P/E) stocks.
Shopping for low P/E stocks is almost like looking for bargains or discounts when it comes to shopping for FMCG, electronic goods, clothes and a whole host of other items.
The logic is similar to bargains on Dalal Street. But before we get into how this works, let us start with the basic definition - price to earnings ratio is the market price of the share divided by the earnings per share (EPS) of the company that is, P/E = stock price/EPS.
Though P/E ratios should never be taken as the sole indicator of the stock value, there is a strong reason why investors look at P/E ratios very closely. It tells you how much investors are willing to pay for every Rs 1 of earnings that a company generates.
That implies that lower the P/E , the lower investors are willing to pay for it. On the other hand, higher the ratio, higher the prices investors are willing to pay. Some stocks like L&T and HDFC will command a very high P/E multiples, primarily because of the confidence investors place on such companies.
At the same time, the performance of these companies has also met investors' expectations and they are willing to pay a good price to own them. Such action was witnessed in power and real estate stocks in the last couple of years where investors were willing to simply pay any amount.
However, most of these stocks have cooled down now and corrected by 60-70 per cent from their peak. Now, very few investors are willing to pay a high price to own them. This was the repeat of what happened to many technology stocks in the late 1990s, and the subsequent painful correction.
Hence, the cardinal rule is to pay as little as possible for good quality companies and then sit tight for a turnaround in their stock prices. The performance of some companies could be good, but it is just that a lot of people are not ready to put their money because the stocks might not be popular. Some savvy-shoppers hope to avoid paying too much by buying stocks with a low P/E ratio. Let us take an example of two companies:
Stock price = Rs 500
EPS = Rs 20
P/E ratio = 500/ 20 = 25
Stock price = Rs 1,000
EPS = Rs 20
P/E ratio = 1,000/ 20 = 50
Though the above companies have the same EPS, their P/E ratios are different because of their market prices. The market does not look at whether the EPS is similar. It is more interested in the growth in EPS. A company's P/E ratio normally reflects investors' expectations of the future growth in EPS.
However, as markets can be irrational P/E ratios may not reflect the ground realities. It is also because market sentiment plays a big role. So, when the market sentiment is really good, nothing else matters.
Ideally, you should not just take a low P/E as a sacrosanct indicator of bargains in the market. But, at the same time just because a stock has a high P/E ratio does not mean it will go down in value or that it's expensive.
A lot of stocks go even higher despite having higher P/E. An important reason for this could be that there are expectations of a sharp rise in the earnings growth. Investors, in such cases, are willing to bet even on a high P/E stock because according to them, the present valuation is cheaper than what it should be. Also, on the other hand, sometimes low P/E stocks continue to languish in the dumps because the market does not fancy their potential.
It is, therefore, paramount that you not only look at the P/E ratios, but also at the earnings growth prospects over next several quarters, quality of management, execution capability and a whole host of other parameters before taking a call.
In short, a strong fundamental evaluation of the business prospects of the company is extremely important before you decide to buy any stock.
The writer is director, My Financial Advisor
