14) PE ratio: An effective screen-test

The PE (price-earnings) ratio is among the basic tools used to measure how cheap or expensive a stock is. This ratio measures the number of times a stock quotes as a multiple of its earnings per share and is also commonly referred to as the PE multiple.

The PE multiple is simply the amount of rupees the market is willing to pay for one rupee of the company's earnings. The inverse of this ratio is known as the earnings yield. In calculating the PE multiple, various time-frames can be used to arrive at the earnings per share — annualised quarterly earnings or future earnings. However, the commonly used time-frame to calculate price-earnings multiple is the trailing 12-month period.
When computing the earnings per share, investors may also have to make a choice between basic and diluted earnings, and standalone and consolidated profits. Conservatively, investors would be better off taking the diluted earnings, as that would factor in potential issue of equity shares on conversion of bond, debentures and preference shares. The importance of diluted earnings stems from the fact that, of late, India Inc. has taken to the FCCB (Foreign Currency Convertible Bond) route to obtaining funds at competitive rates.

Though this strategy augurs well for a company to shore up its earnings, it involves a cost to the shareholder as he has to share the earnings of the company with a new set of shareholders. While choosing between standalone and consolidated earnings, it would be prudent to use the latter as that would capture the overall performance of a company with its subsidiaries.

Once the earnings per share is calculated, the multiple at which a stock trades generally reflects the investors' expectations of earnings growth. Another key factor that drives this ratio is the cost of equity which, in turn, is linked to risk-free return and volatility of the stock.

Value investors tend to adopt a low PE as a rulebook for an investment. While a low PE multiple is desirable, it would be inappropriate to adopt this ratio as a stock-picking tool across industries. Technology stocks tend to quote at trailing 12-month PE multiples between 30 and 40 compared to basic industry stocks that usually have single-digit PE multiples. As such, investors would be better off adopting this tool for peer comparisons within the same sector.

This tool has its own defects; it bypasses investment opportunities in companies that are making losses and are on the verge of a turnaround. For instance, investors who focus on the PE multiple alone may have missed out on stupendous gains in India Cements, which has more than doubled within a space of a year. In December 2005, the company reported a loss on a trailing 12-month basis; however, this December, the stock quotes at a price-earnings multiple of 20.

Adopting moderate price-earnings multiple as a filter, an investor would also miss out on companies with substantial growth prospects. For instance, Infosys Technologies. In December 2005, the stock commanded a price-earnings multiple of about 35 times (trailing 12-month earnings of consolidated entity) and, in today's market, it quotes at about 40 times its earnings. Though it could be argued that the capitalisation factor has gone up by 12 per cent, the stock has gained about 50 per cent within the space of twelve months.

The other defect of a low PE multiple filter is that companies that are just out of the red would be off the radar as they tend to command high PE multiples. Take the case of an investor who had adopted this tool in September 2003. SAIL, which traded at Rs 40, would not have been on his radar then as it quoted at about 60 times its trailing 12-month (standalone) earnings. Within a span of three-and-quarter years, the stock doubled to about Rs 80 (commanding an earnings multiple of 8).

Going by a low PE would also filter out most stocks in the retail, media and technology space and leaving only those in the basic industries. A good number of stocks with a low PE are those perceived to have little opportunity for earnings growth or are highly volatile. Therefore, while the PE multiple is the most commonly used valuation metric, it cannot be the only one you use to decide on an investment.