What exactly do we understand by the P/E ratio of a stock or the index? Most of us understand P/E ratio as the outcome of higher prices. In reality, it is stock P/Es that are the independent factor and prices are actually the dependent factor. That brings us to the question of what is a good P/E ratio for a stock. What are the reasons for high P/E ratio and whether high P/E ratio good or bad for the stock valuations? Obviously, there can be no straight forward answers to these questions and the answers to most of these questions are relative. Eventually it all boils down to a host of fundamental quantitative and qualitative factors which determine the P/E ratio for a stock. Firstly, let us look at the P/E ratio of the Sensex over the last 20 years based on trailing earnings.
From the above chart it can be gauged that the P/E Ratio of the Nifty has been shifting from as low as 15X earnings to as high as 25X earnings. Of course, these are yearly averages and markets have seen much greater volatility during the year. For example in March 2003 and in March 2009, the index was available at 11-12 times P/E. Similarly, in Jan 2000 and in Jan 2008, the Sensex was valued at close to 28 times P/E. But, we get back to our core question of the factors that actually influence the P/E ratio of a stock…
Growth in earnings and sales
This is one of the primary factors driving P/E ratios of stocks. Markets always prefer companies that are able to grow their top-line and their bottom line at a rapid pace. This could be newer markets or due to greater penetration of existing markets. The idea is that investors are willing to pay a higher price for growing stocks than for non-growing stocks. That explains why stocks like Motherson Sumi continue to get rich P/Es because they have proven consistent growth over a period of time. When it comes to growth, what matters are not just the projections but what has been delivered consistently?
Operating profits margins and net margins
This is the classical debate off footfalls and eyeballs over profits. Sales growth is great but is eventually translate into profits. That is what margins come into play. Companies that are able to expand their operating margins (OPM) and their net margins (NPM) consistently over time get better valuations in the market. That is because such companies are showing momentum in converting growth into profits. OPM is given greater importance than NPM.
Return on equity and return on capital employed
The P/E ratio of the stock will be ultimately be determined by the Return on Equity and the Return on capital employed. Equity (consisting of share capital and reserves) is what the shareholders are contributing to your company. They will be willing to pay a higher price only if you earn substantially better returns on the capital. Normally, companies with a large debt component or a large equity base will tend to have lower ROEs. Not surprisingly, such companies will also command lower P/E ratios.
Macro conditions prevailing in the market
This is a very interesting factor and the impact varies from sector. These are mainly anticipatory in nature. For example, when rural incomes are likely to increase you will find the P/E ratio of two wheelers, tractors and FMCG expanding. Similarly, when the capital cycle is looking to turn around you will find the P/E ratio of heavy equipment and capital goods companies turning around. When interest rates are trending lower, then rate sensitives like banks, realty and NBFCs get better P/E valuations.
Stage of the cycle in case of commodities
This is very specific to commodities like steel, aluminium, copper, oil etc. Normally, you will find that these commodity companies tend to command lower P/E ratios compared to sectors like automobiles, IT, FMCG or pharma. That is because, there is not much to differentiate and price is the only factors. But you will find that the P/E ratios of these commodity companies tend to move up when there is clear evidence of the global commodity cycle moving up. Take the valuations of Hindalco today as a classic example.
Brands, distribution networks and other intangibles
P/E ratios are not just about tangibles on the income statement and balance sheet but also about intangibles. You can also refer to them as qualitative factors. In technical parlance they are also referred to as a moat. Many companies are able to differentiate and create an edge. For example, Hindustan Unilever has created an edge through its brands while ITC has created an edge through its unmatched distribution network. These intangibles are a key factor in assigning a higher P/E ratio for select stocks.
Lower debt and lower equity base
This, in a way, could be a repetition of some of the previous points made but the bottom-line is that markets prefer companies that do not have too much debt on their balance sheet. Higher debt means greater financial risk and lower coverage ratios. In fact, if you look at the companies with higher than average P/E Ratio, they are companies that are not leveraged too much and have a low equity base. Eicher Motors is a classic example of the company benefiting from a better valuation due to low leverage and a low equity base.
The moral of the story is that P/E ratio of a stock is determined by a variety of factors; both quantitative and qualitative. The bigger the moat you create in your business, the better your valuations.
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