What is the Earnings Multiple and What does it indicate?

What is the first thing that you check as an investor while making an investment decision in equity markets?

Most of us check the quality of the business done by the company and numerically, we first check its share price. Looking at the price alone will not suffice as it will not give a complete picture.

There is a famous quote –

It all starts with the first step

The same applies to Equity Investing. There are certain multiples and ratios known for the basic analysis of whether to invest in a company’s shares or stay away which are popular amongst the experienced as well as aspiring investors.

One such tool is the Price-Earnings Multiple. Popularly known as the P/E Multiple, this ratio is widely used for doing the basic number crunching by equity investors.

 

What is the Price-Earnings Multiple (P/E Multiple)?

As the name suggests, it considers the Price and Earnings of the company. P/E Multiple is calculated as

The P/E Multiple is also known as Price Multiple, Earnings Multiple, Price to Earnings Ratio, P/E Ratio, PER, etc.

Key points to note with regards to the Price-Earnings Multiple?

  • A high PE Multiple suggests that investors anticipate higher growth in the future.
  • Companies making a loss in the market may not have a Price-Earnings Ratio.
  • There are 2 types of P/E Multiples: A Trailing PE Multiple and A Forward PE Multiple.
  • A high Earnings Multiple suggests that the stock price is high in relation to earnings,means either overvaluation or investors are willing to pay higher price for the share, looking at the bright future prospects of the company.
  • A low Earnings Multiple suggests that the stock price is low in relation to earnings, means either undervaluation or investors are not willing to buy the share, may be due to poor performance or not so good future prospects of the company.

What does it represent and how is it used?

  • The Price to Earnings Ratio represents how much an investor is willing to pay for each rupee earned by the company.
  • This ratio is used to find out whether the company is over-valued, under-valued or reasonably-valued.
  • Used widely by investors and analysts to find out the relative value of a company’s share within a sector/index/industry as compared to peers.
  • Used to compare the historical, current and future earnings estimates of the company.
  • Helps to standardize the value of a rupee throughout the stock market.

What are the limitations of PE Ratio?

  • Valuation and Growth Rates between companies of various sectors differ due to the demand-supply and sector-specific reasons.
  • Gives the best results when used to compare companies within the same sector, may not be as efficient otherwise.
  • Debt taken by the company affects the price and earnings of the company as well. Hence leverages tend to skew the P/E Ratio.
  • Price and Earnings – the 2 parameters are difficult to fetch accurately, as manipulations in earnings by the company are possible and price fluctuations happen day-in and day-out in the market.

For Example:

Stocks with Highest and Lowest Price Earnings Multiple in Nifty 500

Nifty 500 Companies with High Price Earnings Multiple
Sr. No. Scrip Name TTM* PE Multiple
1 ITI Ltd. 209.24
2 Vakrangee Ltd. 165.57
3 Thomas Cook India Ltd 133.62
4 Lemon Tree Hotels 92.47
5 Symphony Ltd 82.41

 

 

Nifty 500 Companies with Low Price Earnings Multiple
Sr. No. Scrip Name TTM* PE Multiple
1 IRB Infrastructure Developers 3.41
2 Gateway Distriparks 2.71
3 Graphite India Ltd. 2.07
4 SREI Infrastructure Finance Ltd. 1.40
5 Cox & Kings (India) Ltd. 0.08

Source: Ace Equity data as on August 29, 2019

Note:

The PE Multiples mentioned above are on a Consolidated Basis

*TTM means Trailing Twelve Months

In conclusion, Price Multiple, being a popular tool for making an investment decision, has its own limitations and hence, should be used with the relevant purpose and studied alongside various other factors which are a market, stock, and company-specific.

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