Understanding Price to Earnings (P/E)

We have just seen a bear market and will now, hopefully, see the beginning of a bull market. But was it really a bear market that we have just seen? Practically speaking, a bear market is one which makes people lose a lot of money and makes people lose confidence in the markets. That has happened, so yes, this was a bear market. Technically speaking, a bear market is one which makes a pattern of lower highs and lower lows. So, while a pattern of lower highs and lower lows is visible on the daily charts, it is still not there on the weekly charts. So, we can say that, technically, we are still in a bull market.

When a bull market starts, blue chips are the first ones to go up. After a while the blue chips become expensive and then the midcaps improve and finally, when even the midcaps become expensive the demand increases for small caps. But why does this happen? Just because a blue chip or a mid cap stock has gone up, would you buy a small cap? The reason most people give is that they are better off buying a larger quantity of the small caps rather than a small quantity of a blue chip.

Let’s say you are of the view that software stocks will do well and want to invest in some software stocks. If you have Rs.20000 to invest, would you rather buy 12 shares of Infosys at 1650, which is giving you over 20% growth, or would you prefer to buy 150 shares of Ramco Systems, which is a loss making company for the last five years, at the price of Rs.136/-? Are you more comfortable buying a quality stock which is expensive or would you rather buy a loss making company which is cheaply available? Would you rather buy a Sony Television for Rs.25000/- or would you buy 5 televisions assembled by your next door neighbour for Rs.5000/- each?

Well, when you want to make money, you have to buy quality stocks. Even 12 shares of Infosys are more likely to deliver better profits than 150 or 200 shares of a company which has been making only losses since the last five years. Does that mean that you have no choice? In fact, you do have choice. When you are selecting a stock first zero in on to the sector/industry you want to invest in. Once you have decided the sector, look at the top 10 companies in that sector. Look at their last five years profit statements. If they have been giving good returns consistently in the last five years, then buy the cheapest of the lot. But how do you decide which is cheapest? The price? No, by way of price, company X may be cheapest of the top ten. But that still may not be the cheapest. The cheapest is which has the lowest Price to Earnings Ratio (P/E). We work on the assumption that similar companies in the same industry should have a similar price to earnings multiple. P/E is the current traded price divided by its Earnings Per Share (EPS). EPS is calculated by taking the profit before interest, depreciation and taxes and dividing it by the total number of equity shares issued.



Let us understand this more deeply. Let us say there are two companies A and B. For convenience sake, let us keep the numbers small and easy to understand. Let’s say A is a large company and has made a profit of Rs.1000/- this year while B is a slightly smaller company and has made a profit of Rs.800/-. Let us say company A has issued 1000 shares and B has issued 400 equity shares. So, the EPS of company A will be Rs.1/- per share (1000/1000) while that of company B will be Rs.2/- per share (800/400). This means that company B is making a profit of Rs.2/- on every share while company A is making only Rs.1/- on every share. So, while company A is making more profits on the whole, it is making lesser profits on each share issued.

Let us look at the price in the markets. Company A is trading at a price of Rs.40/- per share, company B is trading at Rs.50/-. Let’s calculate the P/E now. Company A has a P/E of 40x (40/1) while B has a P/E of 25x (50/2). So while company A may be larger and is making more profits in money terms its price is 40 times its earnings while company B’s price is only 25 times the earnings. This shows that even though the price of A is cheaper, company B is cheaper in terms of P/E. So, from this example, it is clear that it makes more sense to buy company B rather than company A.

So, that is all about EPS and P/E. While I have made every effort to make it as simple as possible, I know a lot of the readers will find some grey areas in this article. I encourage you to please post your comments by clicking on the comments button below in case you still have any doubts regarding these terms.

Happy investing!!!

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Infosys Up, Markets Down

Nifty, after breaking through the 4630-4830 range, opened on a high today with but then failed to maintain the heights. As mentioned yesterday, a bout of profit booking set in because market participants are still scared of the markets and are happy with small profits. There is a lot of resistance to be expected between the 4950-5000 zone. On the way down 4830 and then 4630 are good support levels. Buying for the short term could be done at these levels. A move below 4730 will change the short term trend to down.

As suggested in earlier newsletters, a trend in Nifty can develop only if it goes above 5000 or, God forbid, below 4500. As of now it seems as if going below 4500 is a remote possibility. On the daily charts the Nifty has made a doji pattern which means that the open and closing price were very close to each other. This represents indecision. And since dojis are normally found at the end of short term trends, and since today’s doji was found near the top of the range, we may expect the Nifty to come down for a day or two. It may then decide to find support near 4830/4630 and then reverse or continue its way down to 4480. Let us wait and see what it decides to do. A move above 5000 could take it up to 5450-5500.

Let us look at Infosys Technologies. Two days ago it closed at a price of 1421.90. Tuesday morning it came out with its results which were not brilliant but just in line with the expectations. Considering the hostile conditions in which Infosys was operating, such normal results may be called brilliant. Anyways, in the results, it confirmed that in accordance with its guidance of an EPS (Earnings per Share) of 81.5 given last year, it has actually delivered an EPS of 81.56. At a price of 1421.90 and an EPS of 81.56, the Price to Earnings Ratio (P/E) is 17.43x. For next year Infosys has given a guidance of an EPS of 92.30-93.90. And as is its reputation of exceeding its guidance, it may be able to deliver a growth of 17-19%, lets take it as 18%. At 18% and with the base at 81.56, next year’s EPS is likely to be 96.24. At an EPS of 96.24 and a price of Rs.1421/90- the P/E is only 14.77 which is very cheap. Just to maintain its current P/E of 17.43, Infosys would have to be priced at Rs.1677/-. This is the main reason why we saw it jump in the last two days.

In a year or two, the situation in the US should be better than what it is today. As the situation improves, the P/Es will have to be rerated. At 17x what is expensive today may even be cheap at 25x when the situation is better. Considering that the situation does not change drastically but only becomes a little better, we can easily expect Infosys, a market leader, to be trading at 22x its earnings. With an EPS of 96.24 and a P/E of 22, Infosys would have to be trading at Rs.2117/-. Since the markets always look into the future and assuming that Infosys again gives a guidance of 18% for FY 2009-2010, then the EPS in 2010 would be 113.56 and with an EPS of 113.56 and a price of 2117, it gives a forward P/E of only 18.64x which is not, in any way, stretched. It is very reasonable. So 2100 maybe the target one may be looking at a year from now.

But what do the technicals say? Look at the daily chart of Infosys above. Two good days have pushed the price decisively out of the range between 1400 and 1550. This range breakout gives us a target of between 1650-1700. On the other hand, it has also broken out of its downtrending line and has come back in an intermediate uptrend. The target of this pattern is close to 1950. So, with a little bit of resistance between 1650 to 1700 it may go up to meet its target of between 1900 and 1950. It’s a buy now with a stop loss of 1520.

As mentioned in earlier newsletters, we are inviting our esteemed readers to send in their contributions in the form of articles to be published on this page. Take this opportunity to voice your opinions to the world about the markets today, the markets in general or anything remotely connected to the markets. Please e-mail your articles and don’t forget to mention your name and location so that you are given due credit for the article that is published.

Happy investing!!!

Update: This article was also published on the business and investing page of Reuters.

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Fundamentally Strong Reasons to Buy

Today’s movement did not help the markets much except giving us a day in the green. The markets are still stuck within a range and there are concerns amongst some circles that the markets may break down below the range rather than breaking out upwards. All that is very true. The markets could break down either way. There were some positive signals in the short term charts but those too seem to have fizzled out.

Stocks, or the markets as a whole, cannot be down forever. There has to be some value buying at some level. Agreed, that the GDP growth rate is slowing but it’s still a very good rate of growth. Agreed, that the inflation is rising and that the growth may become still slower but we will be able to control the inflation and the companies will be able to show good earnings despite inflationary pressures. And then the value buying will emerge. The smart money always buys first. We have to ensure that we become smarter and buy with them, if not before them.

Presented below is an analysis of the value and the fundamentals in the Indian markets, which I had received from someone in an email. The source is unknown so cannot give credit where it is due, for the same. The last leg of the recent bull market was driven more because of excess liquidity, leveraging and rumours than because of fundamental reasons. The same situation had been last seen in Feb-Mar 2000 when the markets rose because of the dotcom bubble. After Mar 2000 we saw a huge bear market which lasted almost three years. Is it going to be the same this time too? Let us do some number crunching and look at the fundamentals then and the fundamentals now.

In 2000-01, the markets were trading at a forward P/E (price to earnings ratio) of 35 times while this time they are trading at 16 times. The savings and investments (as a percentage of GDP) which were about 24% that time are now about 35%. The GDP growth that time was 4.35% and now it is 8.73%. Inflation was growing at 7.16% in 2000-01 and is now 4.21% (and is now catching up). What is important is the earnings growth which was (on an average) 4.43% 8 years ago is now between 17-20%. The rally, which at that time was mostly in the Technology, media and telecom sector is more broad based now.

The last 10 years data reveals that while the Sensex now is only 4.1 times of the Sensex then, whereas the total earnings now are 7.5 times of the total earnings then (of the BSE 500 stocks). The EPS (Earnings Per Share) has been showing a growth of more than 30% in the last two years and an average growth of about 25% in the last 5 years. Assuming that the EPS grows by 20% in the next three years, by 17% in the three years after that, 15% in the next block of three years and then by 12% in 2018 and if the P/E ratio stays at 16 times then by 2018, the Sensex should be trading at a value of 63485 in the year 2018. The following table shows what the value of the Sensex should be in each financial year upto 2018 at various P/E levels between 12 and 22, if the EPS follows the growth pattern shown above.

Sensex at 87292 at a P/E of 22 in 2018 is unbelievable. But you never know, with the kind of growth India has been witnessing, that may be very much possible.

The above exercise just goes on to prove that the fundamentals of our country and the Sensex are still very attractive. We should now start to look for buying opportunities whenever they come. A day when there is a gap down opening or a lot of panic should be a good day to start. Buy good blue chip stocks which have excellent fundamentals but have been badly beaten down by the street. These companies, over a period of time, will definitely outperform the broader market.

I remember the time nine years ago when I was doing my MBA and I remember our Portfolio Management professor showing exuberance (and a pleasant shock) over the Dow touching 10000 the previous day. And at that moment I was wondering whether I would ever see the Sensex at 10000 in my lifetime (Sensex was only about 3800 in those days). And I thought that even if I did see Sensex at 10000 some day, Dow would probably be somewhere near 50000 at that time. I didn’t have an idea that when Sensex touched 20000, Dow would have been languishing at 14000 levels. Well, that is history. Lets see what the future holds for us.

Happy investing!!!

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