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.

Understanding Valuation Measures

Valuation is at the heart of all fundamental investing in stocks. It is a science as much as it is an art. The subject is vast and fit for writing a book rather than a small post. For the moment, I will do the easy stuff, a short post for the benefit of new investors.

Let us briefly look at some important valuation measures:

1. P/E: defined as CMP/Diluted EPS where CMP is current market price & EPS is the earning per share. 

Getting it:

Price-to-Earning (P/E) ratio or P/E multiple is the most commonly used indicator. It shows the number of times that the price of a stock is trading relative to its earnings. You can generally find the PE of listed stocks in business newspapers or journals. The best however, is to work out the EPS oneself from the published financial results so as to understand the nuances. Price quote of the stock can be easily found on daily basis from NSE/BSE website or other media sources. Alternatively, EPS can be checked from financial results and/or annual reports published by the company, and P/E can be computed dividing current price by the EPS. For example, Infosys had EPS of Rs 119.40 for FY11, so at a price of Rs 2,906, P/E multiple works out to 24.3.

Making sense of PE:

Low PE ratio stocks are characteristic of either mature companies with low growth potential or companies that are undervalued or in financial distress. Conversely, high PE stocks could be characteristic of high growth companies or very expensive or risky stocks. In that sense PE gives a broad indication of how expensive a stock is, relative to its earnings. Low PE by itself is rarely a sufficient ground to consider a stock undervalued or vice versa. Above discussion is generally for earnings in past financial year or for last 12 month period (trailing twelve months referred as EPS ttm), both of which are rear view mirror.

Remember, markets are forward looking and generally discount the future – the earnings, the growth, the sustainability of earnings etc. So, drawing inferences merely on basis of trailing P/E is not proper. Forward P/E estimates for next FY are quite prevalent. In bull markets, it's not uncommon to see analysts stretching it further and justifying valuations of a stock as acceptable talking about PE on basis of 4 years into the future, say 15x FY2015 earnings estimates.

I will not comment on how high is high PE. Suffice to say, currently the PE of BSE Sensex is 21.02 and that of NSE Nifty is 21.94. Their historical values are also available on exchange websites.

Linking P/E to Growth brings us to PEG ratio that is obtained by dividing P/E by expected growth. Stocks with a low PEG Ratio of say below 1 are seen as better value, even if their P/E is higher, by virtue of the implied value of future earnings. On the same example of Infosys, if the growth rate is 10% (just for illustration), then PEG would be 2.43.

I realize covering each of the valuation measures in some depth will require a very detailed write-up or multiple posts. So I just give the definition for the rest.

2. P/BV: defined as CMP/Book value per share where denominator is Shareholder's equity/Actual number of shares.
3. P/S: defined as CMP/Sales per share where denominator is Annual sales turnover/Actual number of shares.
4. EV/EBIDTA: defined as Enterprise value /EBIDTA where Enterprise value = Market Capitalisation + Net debt + other long term liabilities like pension liabilities, deferred tax etc.
5. EV/Sales: defined as Enterprise value/Sales
6. Dividend yield: defined as Annual dividend per share/CMP.
7. FCF yield: defined as FCF/Market cap where FCF or free cash flow is Cash flow from operations – Total capex.

By no means, above list is exhaustive, and as I mentioned before this is a subject by itself. But as we say if investing could be reduced to mere ratios, quants or mathematics, everyone plugged into numbers would have been super-rich. But that's far from reality simply because valuation is not a number game. Sometime later, I will make a post on sectoral perspective to valuation. 

I conclude with a quote from Philip Fisher:

"The greatest investment reward comes to those who by good luck or good sense find the occasional company that over the years can grow in sales and profits far more than the industry as a whole".