3 Principles to Decide the Ideal PE Ratio of a Stock for Value Investors

Modified on November 1, 2018

Deciding about the ideal PE ratio i.e. the valuation level of any company at which an investor may buy its stock, is one of the key aspects of stock analysis. All the investors have faced the uncertainties about deciding what is the ideal PE ratio to buy any stock? Answering this question is very important because even a very good company if bought at an overvalued price, might not prove to be a good investment.

Therefore, every investor while analysing stocks for investment keeps on continuously asking herself, whether the current price presents an attractive valuation opportunity at an ideal PE ratio or whether she might get stuck in an overvalued stock.

The current article is an attempt to help the reader tread on a guiding path to determine the right price i.e.the ideal PE ratio to be paid for a stock. The article attempts to determine a few of the factors that influence the PE ratio and tries to bring a some objectivity to the approach of determining the ideal PE ratio that the investor might be willing to pay for the stock.

The article would focus on the key criteria that an investor should look at while deciding about the PE ratio (premium or discount) that she may pay for any company (i.e. ideal PE ratio). These criteria would also help her in deciding about the maximum PE that she may pay for those companies, which she had initially bought at very attractive levels but the stocks have now increased in price and PE ratio. Therefore, this article would also help her in deciding her strategy for accumulating stocks which are already existing in her portfolio.

In addition, the article also contains answer to some of the important queries asked by investors in order to provide further clarifications on the calculation and use of PE ratio in valuation.

Every investor has her own favourite valuation ratios, which she determines based on her own experience and preferences. However, I prefer using the price to earnings ratio (PE ratio) as the valuation level for determining the attractiveness of a given stock price of any company.

 

What is PE ratio

PE ratio is the most widely used parameter to analyse whether the stock of any company is overvalued or undervalued at any point of time. It is calculated by dividing the current market price (CMP) of a stock by profit/earnings per share (EPS). It represents the price an investor pays to buy ₹1 of earnings of a company.

To illustrate, if the PE is 10, it means that to get ₹1 of earnings in one year from a company, the investor is paying ₹10. Similarly, if PE is 20, it means that to get ₹1 of earnings in one year from the company, the investor is paying ₹20. If we compare PE ratio of 10 and 20, in the above example, it would become evident that at PE of 20, the investor is paying more money to get the same value of ₹1 in earnings than when PE is 10.

 

Usual ways of finding ideal PE Ratio

Investors interpret PE ratio and its derivatives in multiple ways to decide about the valuation level (ideal PE ratio) of a stock:

  • Comparing PE ratio of the stock with the industry in which the company operates: Industry PE ratio is the average of PE ratios of all the companies of the specific industry listed on the stock exchange. If PE ratio of the stock is higher than the industry PE ratio, it is assumed to be overvalued and vice versa.

(Read: Is Industry PE Ratio Relevant to Investors?)

  • Comparing current PE ratio with historical PE ratio of the stock: if PE ratio is lower than average PE ratio of last 10 years, then stock is deemed undervalued and vice versa.
  • Comparing PE ratio with earnings (EPS) growth rate (PEG ratio) and
  • Comparing PE ratio in form of Earnings Yield (EY) with yield on other asset classes like government securities (G-Sec), Treasury Bills etc.

However, despite presence of such multiple ways of interpreting PE ratio, investors still find themselves unsure about the ideal PE ratio that they should pay for any stock. The fact that the price of the stock is influenced by a multitude of factors like external factors (interest rates etc.) and internal factors (competitive advantage etc.), further complicates the determination of the ideal PE ratio to be paid for the stock of any company.

 

Factors influencing ideal PE ratio

Among all the multitude of factors that influence the potential purchase price (ideal PE ratio) of any stock, we believe that there are three primary factors:

  1. Prevailing interest rate in the economy
  2. Competitive advantage (moat) enjoyed by the company
  3. Circle of competence of the investor

(Out of the three factors mentioned above, the first two factors draw a lot from the article on assessment of margin of safety of a stock. Therefore, it is advisable that, in case the reader has not read the following article earlier, then she should read it in detail before continuing further:

Read 3 Simple Ways to Assess “Margin of Safety”: The Cornerstone of Stock Investing)

Let’s now delve deeper into each of these factors to assess how they influence the potential purchase price of any stock for the investor:

 

1.    Prevailing Interest Rate in the Economy

The prevailing interest rate in the economy influence the stock prices as well as the underlying business of the companies in a significant manner. Therefore, it forms the basis of the process to find the ideal PE ratio for any company.

Investor always compare expected returns from stocks with the alternatives available to them. One of the key alternative asset class available to all the investors is debt funds, whose return depends a lot on the prevailing interest rates. As interest rates fall, the returns from debt funds decline and they lose their attractiveness to investors. As a result, a lot of investors shift their money to stock markets and are ok to accept comparative lower returns from stock markets until the time such returns are sufficient to beat the yields on debt funds. It results in investors willing to pay higher prices to same stocks, which they otherwise would not have paid.

On the contrary, if interest rates are high, then investors have debt funds as a readily available alternate asset class giving them good returns. In such a scenario, attractive by the perceived certainty of returns from debt funds, a lot of investors withdraw funds from equity markets as they are unwilling to take the risk associated with stocks and as a result, they are unwilling to hold the stocks at higher prices. It results in the stock prices, in general, getting depressed at the times of high interest rates.

Moreover, low interest rates lead to easier and cheaper availability of credit/loans to companies and in turn help them grow and post good results/profits. This leads to a lot of investors buying stocks and taking their prices high in low interest rate situations. The reverse happens when interest rates are high. Profits of companies decline and the investors push the stock prices lower.

In an attempt to bring an objectivity to this influence of interest rates of the economy and in turn impact on the ideal PE ratio, the article delves on the concept of margin of safety put forward by Benjamin Graham in his book: The Intelligent Investor.

Read Book Review: The Intelligent Investor

The discussion below uses Earnings Yield as a factor to determine the margin of safety and arrive at the ideal PE ratio that an investor should target for any stock.

Earnings Yield (EY) is calculated as inverse of Price to Earnings (PE) ratio i.e. E/P ratio. It is calculated by dividing the earnings per share (EPS) with the current market price (CMP).

EY provides an idea about the earning/returns that a stock would produce for every ₹1 invested by the buyer in it.

Benjamin Graham advised comparing the EY with Treasury Yield (USA). Similar yield to compare in India is the ongoing yield on Government Securities (G-Sec). The higher the difference between EY and G-Sec/Treasury Yield, the safer is the stock investment.

To illustrate, suppose an investor buys a stock of company ABC Ltd at ₹100. If EPS of ABC Ltd is ₹10 then its PE ratio would be 10 (100/10) and its EY would be 1/10 or 10%. As current G-Sec yield is about 7.50-8.00%, ABC Ltd is a good investment as per Graham’s criteria.

Suppose, after the investor buys the stock of ABC Ltd., its price falls to ₹50, then the PE ratio would become 5 and the EY would become 1/5 i.e. 20%. EY of 20% would attract more and more investors to shift money from bonds markets and use it to buy stocks of ABC Ltd. as it provides an opportunity to invest money at a yield of 20% against G-Sec yield of 8%. This new demand for stocks of ABC Ltd. would increase its stock price and limit the downfall.

The higher the difference between EY and G-Sec/Treasury yield at the time of purchase of the stock, the higher is the cushion in times of adversity i.e. higher Margin of Safety. Therefore, the stocks with higher earnings yield (EY) i.e. the ones with low PE ratio, would provide a higher cushion to the investor during tough times.

Therefore, one benchmark that an investor might keep to determine the maximum / ideal PE ratio to pay for the purchasing the stock of any company can be derived from Government Securities (G-Sec Yield) or the Treasury Yield.

  • If the 10 years G-Sec yield is 10%, then the investor may decide about the maximum/ ideal PE ratio to be paid for a stock as 10 (i.e. 1/10%)
  • If the 10 years G-Sec yield declines to 8%, then the investor may be comfortable at paying an ideal PE ratio of 12.5 (1/8%) for the stocks.
  • If the 10 years G-Sec yield rises to 12.5%, then the investors should pay only an ideal PE ratio of 8 to the stock (1/12.5%)

The article on assessing margin of safety uses the above concept to determine the margin of safety inherent in the purchase price of the stock.

Read 3 Simple Ways to Assess “Margin of Safety”: The Cornerstone of Stock Investing

 

2.    Competitive Advantage (Moat) enjoyed by the Company

Competitive advantage of any company, aka moat, helps it to protect its business, its market, and its margins from competition. As a result, the company is able to generate higher sales growth, sustained/improving profitability margins, significant free cash flows etc. for its shareholders, which in turn influences the ideal PE ratio that an investor may pay for such a company.

The article on assessing margin of safety uses two concepts to determine the margin of safety in the business of a company. These two concepts are:

  1. Self-Sustainable Growth Rate (SSGR)
  2. Free Cash Flows (FCF)

The current article utilizes these two concepts to determine whether the company has a competitive advantage and deserves to be paid any premium in terms of a higher PE ratio over and above the PE ratio arrived by using 10 year G-Sec yields discussed above.

 

2. A) Self-Sustainable Growth Rate (SSGR)

Self-Sustainable Growth Rate (SSGR) is a measure of the growth potential inherent in the business model of a company, which it can achieve using resources generated through its current profits without relying on external sources of funds like debt or equity dilution.

Self-Sustainable Growth Rate (SSGR) utilizes the features of a company’s business model like net profit margin (NPM), dividend pay-out ratio (DPR), depreciation (Dep) and net fixed asset turnover (NFAT) to arrive at the sales growth rate that the company can achieve without leveraging itself.

The formula for calculating SSGR is:

SSGR = NFAT*NPM*(1-DPR) – Dep

(I advise that the readers should read the following article dedicated to SSGR, in case they have not read it already, before proceeding further in order to fully understand the concept and implications of SSGR:

Read Self Sustainable Growth Rate: a measure of Inherent Growth Potential of a Company)

It can be inferred from the above formula, the companies with higher profitability (NPM), operating efficiency (high NFAT) and lower dividend pay-outs (DPR) would have higher self-sustainable growth rate (SSGR).

An investor should compare the SSGR of the company with its current sales growth to see if there is any margin of safety in the business of model of the company:

1) If the SSGR is higher than current sales growth rate:

It means that the company’s business features (NPM, NFAT & DPR) allow it to grow its sales at a higher rate than the current growth rate. In case of economic downturn, the company can safely:

  • reduce its profitability to generate higher demand
  • reduce dividends to conserve funds to make additional investments and
  • invest in fixed assets to improve its plant & machinery/technology (leading to lower NFAT)

in an attempt to maintain its current sales growth rate.

All the above steps would provide funds from business activities and the company would not have to rely on external sources like debt or equity dilution to get funds to maintain its current growth rate. Therefore, the company with higher SSGR can increase their sales growth rate in normal times and maintain current sales growth rate during tough times without leveraging their balance sheet by taking on debt.

This ability to sustain the growth rate in times of stress without impacting the returns to shareholders makes such companies eligible to be paid a premium while purchasing their stocks. An investors may choose to pay a premium over the ideal PE ratio arrived at after considering ongoing 10 years G-Sec yield, to purchase these companies that have SSGR above sales growth rate.

Let us see the examples of companies, which have SSGR higher than their 10 years sales growth rate:

VST Tiller Tractors Limited:

”How

VST Tiller Tractors Limited has an SSGR of more than 45%, whereas it is growing its sales at an annual rate of 15%-17%. SSGR data indicates that the company can grow at a rate much higher than its current sales growth without requiring outside capital in terms of debt/equity dilution. No wonder that the company has shown very healthy growth without raising any debt.

Tide Water Oil Co. (India) Limited:

”How

Tide Water Oil Co. (India) Limited has an SSGR of more than 55%, whereas it is growing its sales at an annual rate of 12%-15%. SSGR data indicates that the company can grow at a rate much higher than its current sales growth without requiring outside capital in terms of debt/equity dilution. No wonder that Tide Water Oil Co. (India) Limited has shown very healthy growth without raising any debt.

We can see that the companies like VST Tiller Tractors Limited and Tide Water Oil Co. (India) Limited, which have SSGR higher than their 10 years sales growth are able to sustain their growth without leveraging their balance sheets. In case of economic downturn, these companies can decide to reduce profitability to generate higher demand, reduce dividends to conserve funds to make additional investments and invest in fixed assets to improve its plant & machinery/technology to maintain their current sales growth rate.

In case of such companies, an investor may choose to pay a premium (higher PE ratio) over and above the ideal PE ratio arrived at after considering ongoing 10 years G-Sec yield.

The premium that an investor might decide to pay for such companies is a personal preference. However, while making investments, I keep a rough guideline of a premium of incremental PE ratio of 1 for every 10% cushion of SSGR over the 10 years sales growth to arrive at the ideal PE ratio.

(Please note that this is a very rough guideline for calculating the amount of premium in terms of PE ratio of which is yet to be established by any statistical estimates).

2) If the SSGR is lower than current sales growth rate:

The investor would notice that such companies are already growing more than their business potential. Such companies usually rely on raising debt or diluting their equity to generate funds needed for investments to generate the sales growth.

These companies usually grow at a sales growth rate which is much higher than their business potential (SSGR). The result is that these companies have to consistently raise debt/dilute equity to raise funds for investments to generate the growth, as their operational business is not able to generate required amount of funds.

Let us see the examples of companies, which have SSGR lower than their 10 years sales growth rate:

Pratibha Industries Limited:

”How

Pratibha Industries Limited has been growing its sales at a growth rate of about 28%-38% over last 10 years, however, its business model indicates that in the current situation it is not able to sustain any growth beyond 5% from inherent sources in the business as its SSGR is almost 1%-5%. Pratibha Industries Limited has to raise almost entire amount of funds to support its growth from additional sources like debt.

It is not surprising that Pratibha Industries Limited has witnessed its debt increase from ₹50 cr. in FY2006 to ₹2,283 cr. in FY2015.

Jai Prakash Power Ventures Limited:

”How

Jai Prakash Power Ventures Limited has been growing its sales at a growth rate of about 35%-45% over last 10 years, however, its business model indicates that in the current situation it is not able to sustain any growth from inherent sources in the business as its SSGR is almost 0%. Jai Prakash Power Ventures Limited has to raise almost entire amount of funds to support its growth from additional sources like debt.

It is not surprising that Jai Prakash Power Ventures Limited has witnessed its debt increase from ₹1,081 cr. in FY2006 to ₹22,901 cr. in FY2015 and recently has to resort to selling its assets to repay its lenders.

An investor would notice that the companies that grow at a rate higher than what their business model can fund have to face stress going ahead when the debt burden increases to unsustainable levels.

An investor might feel that she may invest in such companies by buying them at a discount to the ideal PE ratio arrived at after considering ongoing 10 years G-Sec yield, just as she decided to buy the companies with SSGR higher than sales growth at a premium. However, it is advised that the investor should avoid investing her hard earned money in such companies and try to find out other opportunities where companies are growing within their SSGR.

 

2. B) Free Cash Flows

As described in the article on margin of safety: 3 Simple Ways to Assess “Margin of Safety”: The Cornerstone of Stock Investing , I believe that free cash flow (FCF) is the ultimate measure of investibility of any company.

It is calculated as the surplus cash with the company after meeting its capital expenditure requirements.

FCF = CFO – Capex

Where,

Capex for any year can be calculated as the difference between gross fixed assets (GFA) & CWIP at start of the year and end of the year. It can also be calculated by deducting net fixed assets & CWIP at start of the year from the net fixed assets & CWIP at end of the year and adding back the depreciation for the year.

Capex:

(GFA + CWIP) at the end of the year – (GFA + CWIP) at the start of the year

OR

(NFA + CWIP) at the end of the year – (NFA + CWIP) at the start of the year + Depreciation for the year

Free cash flow (FCF) is the most essential feature of any business as it amounts to the surplus/discretionary cash that the business/company is able to generate for its shareholdersFCF is the equivalent of savings for a household.

If we as households are not able to manage our expenses within our means of income, i.e. are not able to save anything, then our financial health is going to suffer a lot in future. We would have to borrow from relative/banks etc. to meet our requirements. The debt, which we raise to fund our expenses, needs to be paid at predefined intervals irrespective of the fact whether we are able to save in future/have our job intact or not. The debt pressure increases the bankruptcy risk and leads to stress in our lives.

The scenario is exactly the same for companies as well.

If a company does not have positive free cash flow, it means that it is spending beyond its means. Such a company would have to raise funds from additional sources like debt or equity dilution to meet its requirements. These funds, if raised from debt, would decrease profitability by interest expense and increase bankruptcy risk and if raised from equity, would lead to dilution of stake of existing shareholders.

In both the cases, the situation of companies continuously raising debt/equity to meet their cash flow requirements becomes less attractive for investors as compared to the companies that are able to meet their funds requirements from their cash flow from operations.

It might be argued that the investments done today by the company would lead to revenue & profits in the future and would generate wealth for the shareholders.

This argument is a valid argument just like an educational loan for an individual. An education funded by loan is an investment, which has the potential of increasing the skills set, earnings ability and future wealth of a person and therefore is considered a good investment.

Similarly, for companies the investments in plants & machinery and technology is like educational loan, which increases future earnings potential. Therefore, we should worry about a situation where a company is not able to generate positive FCF for a few year. Such companies might be taking education loans to generate future wealth. However, if a company is not able to generate positive FCF over long periods of time (I assess them over last 10 years), then the company resembles a continuous cash guzzling machine.

It resembles an individual who is continuously garnering degrees after degrees costing millions of rupees/dollar, without ever putting those skills to commercial use. Or those degrees might be fake and cash has already gone down the drain! In both the cases, the investment done is not of much use.

I, as a shareholder, expect the companies I own, to be cash generating machines. Their business should be source of cash for me and not the other way round. Therefore, positive free cash flow generation by a company over last 10 years, is one of the key criteria for stock selection for me.

Once an investor has identified a company with positive cash flow, then she should further analyse what proportion of cash flow from operations (CFO) over last 10 years, it has used in capital expenditure (capex) and what proportion is available as free cash flow (FCF%).

 

Free Cash Flow% (FCF%) and Margin of Safety:

I find that the companies, which have achieved their sales growth in the past by using minimum amount of CFO as capex have significantly higher margin of safety over the companies which have used almost all CFO. Needless to say, the companies, which have their capex much higher than their entire CFO over last 10 years (i.e. negative FCF), have very low/negative margin of safety.

An illustration:

Let’s take an example of two similar sized companies (A & B) growing their sales at a similar rate (say 15%) in the past. Let’s assume that both the companies A & B, generated same amount of CFO over last 10 years (say ₹100 cr).

Let’s assume that on analysing the capex done by these companies in last 10 years, we find company A has achieved the sales growth (15%) by doing a capex of ₹50 cr (50% of CFO), thereby, generating a FCF of ₹50 cr. On the contrary, we find that the company B has achieved the same sales growth (15%) by doing a capex of ₹100 cr (100% of CFO), thereby, generating NIL FCF.

When the tough times strike the economy in future, the profitability of companies would decline, customers would delay the payment of cash, suppliers would ask for immediate cash and the credit from all sources would become costly.

In such a situation, company A, whose business model permitted it to achieve the sales growth by using only 50% of CFO in the past, would be able to bear the impact of reducing cash inflows as customers cancel their orders, squeeze profit margins and delay the payments. Theoretically, company A can tolerate its profitability and cash collections (CFO) declining by 50%, before signs of stress start becoming visible on its business operations & planned investments.

On the other hand, company B, which was already investing 100% of its CFO to generate its sales, would find even the slightest decline in its cash flow (CFO), impacting its operations. Declining orders, reduced profitability and delayed payments from customers would make it difficult for company B to make payments to its suppliers and do planned investments. Company B would have to rely on additional debt/equity raising to fund its cash requirements.

If there is another company C, which was already using more than 100% of its CFO in capex, thereby having negative free cash flow (FCF). Such a company would already be sagging down under lot of debt burden. In tough economic situation described above, company C would find difficult to continue its business operations as usual as sources of cash dry up. The additional debt, which was essential to sustain its business model, would become further costly.

Companies like C are prime candidates for bankruptcy in tough times as they find it difficult to service exiting debt, make payments to suppliers. Such companies, usually being capex heavy and operating at low profit margins, find it difficult to garner additional business by reducing their profitability as it would push them into losses. Such companies rarely have any margin of safety built in their business model.

Free Cash Flow% (FCF%) and the ideal PE Ratio

Let’s see the examples of some of the companies from the perspective of FCF and try to determine if they deserve any premium in terms of PE ratio over and above the PE ratio arrived at after considering ongoing 10 years G-Sec yield to arrive at their ideal PE ratio.

 

1. Companies with Positive Free Cash Flow (FCF):

Atul Auto Limited:

”How

Over last 10 years (FY2006-15), Atul Auto Limited has generated cash flow from operations (CFO) of ₹168 cr. whereas it needed to invest only ₹88 cr. in its business and thereby leaving ₹80 cr. (48%) in hand of the company as discretionary cash to reward its shareholders. No wonder, the company could provide dividends to the tune of ₹35 cr. over last 10 years despite remaining virtually debt free.

The investor may read an analysis of Atul Auto Limited in the following article: Analysis: Atul Auto Limited

TTK Prestige Limited:

”How

Over last 10 years (FY2006-15), TTK Prestige Limited has generated cash flow from operations (CFO) of ₹663 cr. whereas it needed to invest only ₹385 cr. in its business and thereby leaving ₹278 cr. (42%) in hand of the company as discretionary cash to reward its shareholders. No wonder, the company could provide dividends to the tune of ₹156 cr. over last 10 years despite remaining virtually debt free.

We can see that the companies like Atul Auto Limited and TTK Prestige Limited, which have generated positive free cash flows (FCF) are able to sustain their growth without leveraging their balance sheets. During tough times, such companies can reduce prices of its products, offer higher credit period to its customers, pay suppliers promptly to attract and retain quality suppliers without impacting its balance sheet.

These companies would not need to raise debt for such crisis strategies; only a slight reduction in the dividend pay-outs to the shareholders would provide enough of money to fund the emergency measures.

In case of such companies, an investor may choose to pay a premium (higher PE ratio) over and above the PE ratio arrived at after considering ongoing 10 years G-Sec yield to arrive at the ideal PE ratio.

The premium that an investor might decide to pay for such companies is a personal preference. I believe that any investible company must have positive FCF to the tune of 25%-30% of its CFO while using the balance 70%-75% of CFO to fund a respectable sales growth. Therefore, while making investments, I keep a rough guideline of a premium of incremental PE ratio of 1 for every 10% cushion of FCF% above minimum 25-30% for companies that have been growing their sales above 15% per annum for last 10 years.

(Please note that this is a very rough guideline for calculating the amount of premium in terms of PE ratio of which is yet to be established by any statistical estimates).

 

2. Companies with Negative Free Cash Flow (FCF)

Now, let’s see some cases where companies have grown beyond their means (CFO) and have done more capex than its inherent business strength permitted.

Bhushan Steel Limited:

”How

Over last 10 years (FY2006-15), Bhushan Steel Limited has generated cash flow from operations of ₹10,312 cr. However, its business required it to invest ₹41,255 cr in the company, thereby eliminating any chance of free cash flow. The company, on the contrary, had to raise debt to fund its capital expenditure requirements. Total debt of the company increased from ₹2,036 cr. in FY2006 to ₹39,079 cr. in FY2015.

If an investor analyses deeply, then she would notice that the entire dividend of ₹97 cr., paid by the company over last 10 years has been funded by debt.

National Fertilizers Limited:

”How

Over last 10 years (FY2006-15), National Fertilizers Limited has generated negative cash flow from operations of ₹ (1,766) cr. However, its business required it to invest ₹4,395 cr in the company, thereby further deepening the negative cash flow position. The company, on the contrary, had to raise debt to fund its capital expenditure requirements. Total debt of the company increased from ₹227 cr. in FY2006 to ₹7,645 cr. in FY2015.

The investor would notice that the entire dividend of ₹295 cr., paid by the company over last 10 years has been funded by debt.

If the economic scenario deteriorates further, then companies like Bhushan Steel Limited and National Fertilizers Limited would have to meet its cash requirements by raising further debt or equity. In case its lenders or shareholders, do not provide this capital, then the company would face difficult time to tide over the crisis and may resort to sell assets to repay lenders or face bankruptcy.

Looking at the above situation, it is clear that companies like Bhushan Steel Limited and National Fertilizers Limited do not have a significant margin of safety built into its business model.

An investor might feel that she may invest in such companies by buying them at a discount to the ideal PE ratio arrived at after considering ongoing 10 years G-Sec yield, just as she decided to buy the companies with positive free cash flow (FCF) at a premium. However, it is advised that the investor should avoid investing her hard earned money in such companies and try to find out other opportunities where companies are growing while maintaining a positive FCF.

The investor should note that positive FCF should be a necessity before considering any company for investment and the fact that higher the FCF as proportion of CFO, the higher the margin of safety.

 

3) Circle of Competence of the Investor

An investor should prefer to invest in the companies, which are in her circle of competence i.e. the companies where the investor understands the products, the markets, the management, the industry etc.

The investor should continuously try to expand her circle of competence by reading more and more about companies and industries. It is one of the key requirements from a stock investor.

Read: How to Analyze Companies in Industries new to you?

Investors usually have a lot of knowledge about companies that are:

  • from the industry in which the investor works
  • already part of investor’s portfolio where the investor had selected the company after doing significant research

It is a known fact that the investors can take informed decisions about the companies that are within their circle of competence and thus have a key advantage over other investors while deciding about investments in these companies. This advantage is also a form of Margin of Safety.

I believe that in case the investor is not finding good opportunities in the markets at very attractive prices, then she can pay a little premium to purchase stocks of companies in her circle of competence.

To illustrate, assuming an investor has a criteria of purchasing companies at an ideal PE ratio of 10 or lower but is not able to find any new company to add to the portfolio, which is priced at a PE ratio of 10 or below. In such a case,  she may think of buying additional quantities of stocks already existing in her portfolio by increasing her ideal PE ratio by paying a little premium say PE ratio of 11. This is with the assumption that the investor has selected the stocks in her portfolio by doing sufficient research and has been monitoring the stocks on a continuous basis and is well aware about the management, business, products and markets of the companies in her portfolio.

 

Conclusion:

With this, we come to an end of the current article, which focused on the key criteria that an investor should look at while deciding about the ideal PE ratio that she may pay for any company. These criteria would help her in deciding about the maximum PE that she may pay for a company, which she has initially bought at very attractive levels but the stock has now increased in price and PE ratio. This might help the investor in deciding her strategy for accumulating stocks which are already existing in her portfolio.

To summarize, the investor may use the following approach in determining the ideal PE ratio to pay while buying a stock:

  1. Prevailing Interest Rate in the Economy:
    • The investor should use the 10 year government securities (G-Sec) yield/treasury yield to arrive at a benchmark PE ratio at which she may decide to pay a premium or a discount depending on the other parameters about the company. Lower interest rates/yield scenarios would lead to higher PE ratios and vice versa.
  2. Competitive Advantage (Moat) enjoyed by the Company:
    1. Self-Sustainable Growth Rate (SSGR): If the company has an SSGR, which is higher than the last 10 years annual sales growth rate, then the investors may decide to pay a premium over the benchmark PE ratio arrived at after considering ongoing 10 years G-Sec yield, for buying the stocks of the company i.e. the ideal PE ratio for these companies would be higher.
      • The investor should avoid companies, which have SSGR much lower than the 10 years annual sales growth rate and as a result are growing beyond their business potential by continuously raising debt.
    2. Free Cash Flow% (FCF/CFO): An investor may decide to pay a premium over the benchmark PE ratio arrived at after considering ongoing 10 years G-Sec yield, for buying the stocks of the companies which generate high free cash flow as a proportion to their cash flow from operations (FCF/CFO).
      • The investor should avoid companies, which have negative free cash flows and are funding their growth/normal business operations by raising debt.
  3. Circle of Competence of the Investor:
    • In case the investor is not able to find any new stock, which is within her comfortable PE ratio range, then she may decide to pay a little premium to invest in stocks, which are within her circle of competence. These stocks may be from the existing portfolio of the investor, which she has selected after doing sufficient research or may be from the industry that the investor knows thoroughly about.

In the current article, I have shared the learning that I have had in my investing journey related to the finding attractive investment opportunities at attractive prices while maintaining a healthy margin of safety, which I believe that could be useful to other investors.

Let us now answer some of the important queries related to PE ratio asked by investors.

 

Investors’ Queries: Price to Earning Ratio (PE Ratio)

 

Which PE ratio should be used: Forward PE Ratio or Historical PE Ratio?

Dear Vijay,

Do we look at the forward P/E ratio or historic P/E ratio? That seems to be one big debate always, particularly, more so in current situation. With the Government unleashing reforms slowly, would it make sense to look at forward P/E ratios?

Author’s Response:

Thanks for the comment!

I believe in limiting myself to P/E ratio based on historical earnings and not to use forward earnings. While reading the book “The Intelligent Investor” by Benjamin Graham with commentary from Jason Zweig, I came across a section which deals with the dilemma shown by you. I would quote the same para from The Intelligent Investor:

“Graham recommends limiting yourself to stocks whose current price is no more than 15 times average earnings over the past three years. Incredibly, the prevailing practice on Wall Street today is to value stocks by dividing their current price by something called “next year’s earnings.” That gives what is sometimes called “the forward P/E ratio.” But it’s nonsensical to derive a price/earnings ratio by dividing the known current price by unknown future earnings. Over the long run, money manager David Dreman has shown, 59% of Wall Street’s “consensus” earnings forecasts miss the mark by a mortifyingly wide margin—either underestimating or overestimating the actual reported earnings by at least 15%. Investing your money on the basis of what these myopic soothsayers predict for the coming year is as risky as volunteering to hold up the bulls-eye at an archery tournament for the legally blind. Instead, calculate a stock’s price/earnings ratio yourself, using Graham’s formula of current price divided by average earnings over the past three years”

After reading this from the holy book of value investors, I never believed in analysts’ valuations based on future earnings.

Read: How to do Valuation Analysis of a Company

Hope it helps. I would recommend you to read The Intelligent Investor, if you have not read it already. It is a very good book.

Hope it helps.

 

What is the impact of Market PE ratio and Industry PE ratio on PE ratio of individual stocks?

Nice Article Vijay … 🙂 According to my observations till now, P/E ratio also depends on industry of operation and state of market also.

What were the debt (ratios) considerations when you took these stocks? When a company is reducing debt by restructuring or other process, P/E expansion takes place. You are right that it’s very difficult to identify good stocks with P/E <10. 🙂

Author’s Response:

Thanks for the feedback! I am happy that you liked the article.

You are right that P/E ratio also depends on industry and state of market. Say average P/E of FMCG industry would be higher than mining industry. However, within same industry you would find companies trading at a wide range of P/E ratios. For example, if you see the P/E ratios for tyre manufacturers in India, it varies among players like Modi Rubber Limited 7.12 to Apollo Tyres Limited: 22.82 to even 46 for Krypton (data taken from moneycontrol at Jan 31, 2014).

Therefore, I believe that in any industry at any given point of time you would find low P/E companies. The important step is to identify whether these low P/E companies are good companies ignored/undiscovered by markets or fundamentally bad companies which are rejected by markets. The role of an investor is to understand this differentiation and the main purpose of this website is to help common investors like us, to become able to differentiate a good company from a bad company.

You may read more about our thoughts on the impact of Industry P/E here: Is Industry P/E Ratio Relevant for Investors?

If an investor prepares a checklist of parameters strictly screens every stock on the parameter, she would be able to differentiate a good company from bad one. The checklist that I follow is here:

Final Checklist for Buying Stocks

I prefer low debt companies. The debt to equity ratio (D/E) of Mayur Uniquoters when I bought was about 0.1 and currently at FY14 end it was about 0.2. For Vinati Organics, D/E ratio was 0.5 when I bought it, which at end of FY14 stood at 0.4. International Finance Corporation (IFC) had converted its FCCBs into equity in FY15, therefore, the debt has come further down post March 31, 2014.

My investment philosophy is to gain from P/E expansion which happens when fundamentally good companies growing at good rate, are discovered by market participant post my purchase. I am able to find such companies in sub ₹500 crores (₹5.00 billion) market capitalization segment.

You are right that companies showing good recovery post restructuring, see P/E expansion. However, I have not looked at this segment of opportunities yet.

I would like to know about your stock selection approach. Share it with readers and me. It would be a good learning for all of us.

 

Follow-up Query:

Hello Vijay,

I am a beginner in stock market and I get lots of help from my father who have been investor from more than 25 years. I would categorize my style of investing as Value Investing. I try to grab good companies at fair price. I believe in having patience and companies having bad quarters is common and main thing that matters is capabilities of management.

I always gives preference to dividend paying companies as it tells much about management (you already mentioned all this in your articles). I don’t limit myself to limited number of stocks as far as I can get a fair price 🙂 ONGC, HPCL, BPCL, IOC, ITC, HUL all were available at fair prices in 2012 when market was hovering around 5500… I increased positions in all of them during that time. I can’t compare returns of these companies with growth companies as both are in different categories. It will take time for me to understand about picking up growth companies and will wait for that.

Page Industries Limited, SRT Finance Limited, TITAN Company Limited, as an initial investor since time of their inception (my father) in all these stocks I know what growth companies (still holding except SRT Finance Limited) with good management can do for you 🙂

I might be little late in entering into finding these growth companies as 2008-2013 was golden period for someone looking for growth companies, but nevertheless we will have lots of opportunities. We need to wait and have patience :).

Apart from Large Cap, I am invested in L&T Finance Holding Limited (from ₹45), Swaraj Engines Limited for now and will be holding it for long term (at least 5 years till their results are in line). I am waiting for Snowman Logistics Limited to come down to enter into it till ₹75-80 (was unlucky in its IPO), their business model is unique and I am seeing growth prospects for now. Let’s wait and see, how they will be utilizing investors’ money in next 6 months 🙂

Author’s Response:

Thanks for sharing details of your stock picking approach along with your portfolio. It is helpful for me and would also help other readers.

It is nice to have someone near & dear with experience in markets as it would give you much needed guidance during different times. Happy for you!

Congratulations for building a good portfolio and buying stocks during tough times, which I believe that every fundamental investor should do.

I believe that an investor is never late while entering market because time of stay in market is the most important factor which would influence returns. Best time to invest is now. Future is bound to show corrections and if an investor can maintain buying habit, then she might get good stock at discounted prices in future as well.

Nice to have your inputs on the website.

 

It’s your turn now.

Share your experiences and let the other readers and the author know about the ways you assess the ideal PE ratio or the purchase price of any stock while making an investing decision. It would be a pleasure to read your experience and investing strategy.

It would be great to have your feedback about the current article and the website.

P.S.

 

DISCLAIMER

  • The above discussion is only for educational purpose to help the readers improve their stock analysis skills. It is not a buy/sell/hold recommendation for the discussed stocks.
  • I am registered with SEBI as an Investment Adviser under SEBI (Investment Advisers) Regulations, 2013.
  • Currently, I do not own stocks of the companies mentioned above in my portfolio.

"Peaceful Investing": My Stock Investing Approach

“Peaceful Investing” approach is the result of my more than a decade of experience in equity markets. This approach helped me invest even when I had a full-time corporate job and could not spare a lot of time for stock analysis. During my investing journey, I have faced all the common challenges of the investors, the biggest one being “scarcity of time”. “Peaceful Investing” approach keeps in mind that an investor will have limited amount of time to spare for stock investing. 

The objective of “Peaceful Investing” approach is the selection of such stocks, where once an investor has put in her money, then she may sleep peacefully. Therefore, if later on, the stock prices rise, then the investor is happy as she is now wealthier. On the contrary, if the stock prices fall, even then the investor is happy as she can now buy more quantity of the selected fundamentally good stocks.

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