Price earning ratio, commonly known as PE Ratio is the most commonly used tool for valuing the company. Thumb rule being “Lower the PE, better is the valuation of the company”.
But this very tool could be as deceptive as it could become. So, this article will highlight 3 instances where despite having a good PE, a company is usually not worth its valuation.
Before getting into the main content I shall give you a brief idea about PE ratio. PE Ratio is the ratio that shows how much time of yearly earnings per share you need to pay to purchase a company’s share.
Example: If a company is trading at a price of ₹24 at the stock exchange and its earnings per share for the year is ₹2, then in this case the PE of the company or share shall be 12 (i.e.., To acquire one share of a company, the investor needs to pay the price which is 12 times of its yearly earning. Which is 12 times of ₹2 that is ₹24 in this example).
So with the above example, you get to know that the thumb rule must work in an ideal situation (Lower the PE means better are the valuations of Share).
Ideally, your earning must be equal to or must be near to equal with the cash generated by the business. But neither we are living in the ideal world nor the clever corporates want to reveal their “ideal” situation.
In the real world, businesses make large sales on credit. Which results in blockage of tonnes of cash for months. And this very trait of a business is not evenly reflected in the face of profit statement.
Accounting rules all over the world fail to differntiate the cash sales and credit sales on the face of the profit statement and this basic glitch fails to show the real picture of the business.
As PE Ratio considers the “earning” as the base of the formulae hence it rewards a business doing credit sales at par with business doing cash sales. Where in the first case there is always a risk of losing cash in the form of bad debts.
Small Eye Opener: Fraud companies engage in the practice of posting bogus sales in the books which in reality never generates any cash which leads to manipulation in PE and that is used as a tool of deception for defrauding many investors.
A simple question for all of you. There is a Company, let’s call it Company A which uses capital expenditure of ₹5000 to generate ₹50 in a year. And then there is another company, Company B which uses capital expenditure of ₹500 to generate ₹50 in a year. Now in which company would you like to invest? A or B? Given that according to the market price of a share of both the company, the PE ratio of both the company is 10.
Easy to choose, right? Each one of you would choose Company B. But Why? Coz you know it is less risky and uses fewer resources to generate an equivalent income to Company A for its shareholder.
So here it is, you got my point. PE in itself fails to recognize the cap-ex done behind generating this income. And most investors fall in the trap of choosing more Capital intensive businesses by limiting their analysis to PE Ratio.
Small Eye Opener: To manipulate PE, management sometimes gets into false practices of capitalizing operating expenses so that earning could be beefed up.
Again, a simple question for all of you. There is an ambitious company A with a huge growth prospect, which is in its initial stages, and hence due to the business’s initial traction, it could earn you just ₹10 against your invested amount of ₹100. And then there is another company B, which has taken your invested amount of ₹ 100 and made a fixed deposit in a bank and gave you a return of ₹10.
Which company would you choose? Obviously, A, coz you are not here to earn returns on fixed deposits. You are here to make your money grow over time with the business you are invested in.
Which means PE Analysis considers only earning for its calculations. It fails to reward businesses with great operating activities and treats operating and non-operating income as same.
Small Eye Opener: To manipulate the market price, management sometimes indulges in the practices of beefing up their income by booking profit on their investments. So next time, be more cautious when you see a company trading at a low PE.
Investors usually compare the PE of their favorite company with its industry or their competitor’s PE and tend to invest if PE is at the lower side. Let me give you a whole another insight into this PE thing. Let’s just reverse this PE. What do we get? You get a ratio that tells you the earning you get against the price of the share you paid.
Example: (Just reversing the initial example): ₹2 is the earning your company earns for you for every ₹24 you invest in the share. So basically, your return on investment would be 8.33% (Mind you I am using “Earning” and not cash for the calculation).
So my friend why would you invest your hard-earned money in a volatile market to get just a return of 8.33% when you can earn a similar return on safer instruments??
So next time when you invest, use PE and Reverse PE with a more holistic approach and earn more.