What drives PE of a Stock

While dealing with the topic of valuation measures in the previous post, we discussed Price-to-Earning (PE) multiple. In the simplest terms, stock price can be seen as product of EPS and PE as given below:

1.       Stock price = EPS ttm  x PE ttm

2.       Stock price = EPS forward x PE forward

In equation (1), EPS and PE ttm are trailing twelve months say for FY2011 at this point.

In equation (2), EPS and PE are 1-year forward, for FY2012 (sometimes 2 year forward say for FY2013).

EPS is known or quantifiable. For FY11, EPS ttm is already known from the financial results. On forward EPS, many companies/their managements like Infosys give guidance for next fiscal i.e. FY12. Moreover, analysts work out earnings estimates for most companies based on revenue growth, margin structure etc. In other words, forward earnings estimates are known to the markets though these estimates can go for a toss due to factors such as business under-performance, hikes in raw material price, margin pressures, equity dilution during the year and so on. Still, a broad idea on forward EPS is available.

That means in both the above equations, we have PE as the real unknown. One more way of looking at PE is as the number of years it will take to earn back the initial investment. Having said that, PE ttm in equation (1) is just a derived figure since EPS ttm is known and fixed in history. That leaves the forward PE in equation (2) as the magic number or the X-factor that makes investing difficult since forward earnings are uncertain and nobody can be sure whether markets are going to de-rate, maintain or re-rate this PE multiple with the passage of time.

So, the question is what drives this forward PE?

Well, a lot of factors including the following (listed not necessarily in order of importance):

(a) Earnings growth rate trend;

(b) Sustainability of earnings in future;

(c) Return on capital (ROE/ROIC/ROCE);

(d) Free cash flow generation;

(e) Barriers to entry;

(f)  Status within industry : leadership/also-rans/laggards;

(g) Peer comparison & positioning;

(h) Cyclical trend;

(i)  Management trackrecord;

(j)  Shareholder friendliness of management– dividend policy, bonus/rights;

(k) Sectoral outlook;

(l)  Trading volume: like index constituent, FnO trading;

(m) Market perception & sentiment.

Different determinants have varying influences and dynamics. Big money is made when you hold a stock whose PE is being re-rated by the market and one is lucky enough to spot it before that sets in, and hold it through this process. TTK Prestige is a recent example which got phenomenally re-rated by the markets in 2010.

Ultimately, it's the sum total or interplay of different factors that makes up the PE and market keeps adjusting it on a daily basis.