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

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 investors have faced uncertainties about deciding what the ideal PE ratio is 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 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 on 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 that already exist in her portfolio.

In addition, the article also contains answers to some of the important queries asked by investors in order to provide further clarification on the calculation and use of the 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 the PE ratio?

The PE ratio is the most widely used parameter to analyse whether the stock of any company is overvalued or undervalued at any point in time. It is calculated by dividing the current market price (CMP) of the stock by profit/earnings per share (EPS). It represents the price an investor pays to buy ₹1 of the 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 the PE ratios of 10 and 20, in the above example, it would become evident that at a PE of 20, the investor is paying more money to get the same value of ₹1 in earnings than when the PE is 10.

Usual ways of finding the ideal PE Ratio:

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

• Comparing the PE ratio of the stock with the industry in which the company operates: Industry PE ratio is the average of the PE ratios of all the companies of the specific industry listed on the stock exchange. If the 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 the current PE ratio with the historical PE ratio of the stock: if the PE ratio is lower than the average PE ratio of the last 10 years, then the stock is deemed undervalued and vice versa.
• Comparing the P/E ratio with the earnings (EPS) growth rate (PEG ratio) and
• Comparing the P/E ratio in the form of Earnings Yield (EY) with the yield on other asset classes like government securities (G-Sec), Treasury Bills etc.

However, despite the presence of multiple ways of interpreting the 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 Determining the Ideal PE Ratio for a Stock

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

1. The prevailing interest rate in the economy
2. Competitive advantage (moat) enjoyed by the company
3. Circle of competence of the investor
4. Stable business premium

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

A) Prevailing Interest Rate in the Economy:

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

Investors always compare expected returns from stocks with the alternatives available to them. One of the key alternative asset classes available to all 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 comparatively 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 for the 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, attracted 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 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 driving 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 objectivity to this influence of interest rates on the economy and, in turn, impact on the ideal PE ratio, the article delves into the concept of margin of safety put forward by Benjamin Graham in his book, 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 the inverse of Price to Earnings (PE) ratio, i.e. E/P ratio. It is calculated by dividing the earnings per share (EPS) by the current market price (CMP).

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

Benjamin Graham advised comparing the EY with the Treasury Yield (USA). A 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 the stock investment.

To illustrate, suppose an investor buys a stock of company ABC Ltd at ₹100. If the 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 the 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%. An EY of 20% would attract more and more investors to shift money from bond markets and use it to buy stocks of ABC Ltd., as it provides an opportunity to invest money at a yield of 20% against a G-Sec yield of 8%. This new demand for stocks of ABC Ltd. would increase its stock price and limit its downfall.

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

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

• If the 10-year G-Sec yield is 10%, then the investor may decide on the maximum/ ideal PE ratio to be paid for a stock as 10 (i.e. 1/10%)
• If the 10-year G-Sec yield declines to 8%, then the investor may be comfortable with paying an ideal PE ratio of 12.5 (1/8%) for the stocks.
• If the 10-year 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 the 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

B) Competitive Advantage (Moat) enjoyed by the Company:

The competitive advantage of any company, also called the moat, helps it to protect its business, its market, and its margins from the 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 the 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 utilises 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 at by using 10-year G-Sec yields discussed above.

While assigning premiums, an investor should avoid double-counting. In many cases, high SSGR and positive FCF reflect the same underlying strength of the business. As a result, an investor may consider using only one of them for assigning a premium, i.e. either SSGR or FCF, based on her comfort and conviction.

1) 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) utilises the features of a company’s business model, like net profit margin (NPM), dividend payout 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, please read Self Sustainable Growth Rate: a measure of Inherent Growth Potential of a Company

It can be inferred from the above formula that the companies with higher profitability (NPM), operating efficiency (high NFAT) and lower dividend pay-outs (DPR) would have a 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 model of the company:

a) If the SSGR is higher than the 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 the case of an 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 a higher SSGR can increase their sales growth rate in normal times and maintain the current sales growth rate during tough times without leveraging its 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 investor may choose to pay a premium over the ideal PE ratio arrived at after considering the ongoing 10-year G-Sec yield to purchase these companies that have SSGR above the sales growth rate.

Let us see the examples of companies that have SSGR higher than their 10-year sales growth rate:

i) India Nippon Electricals Ltd:

India Nippon Electricals Ltd, a TVS group company, manufactures electrical ignition systems for automobiles (two-wheelers, three-wheelers), and gensets (portable generators).

While analysing India Nippon Electricals Ltd, an investor noticed that the company has an SSGR of more than 35%-40%, whereas it is growing its sales at an annual rate of 9%.

SSGR data of India Nippon Electricals Ltd 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 the company has shown very healthy growth without raising any debt.

An investor may read our complete analysis of India Nippon Electricals Ltd in the following article: Analysis: India Nippon Electricals Ltd

ii) Stovec Industries Ltd:

Stovec Industries Ltd is a leading producer of printing machines & consumables for textile printing and graphics printing. The company is a part of the SPGPrints group of the Netherlands.

While analysing Stovec Industries Ltd, an investor noticed that the company has an SSGR of about 50%, whereas it is growing its sales at an annual rate of 15%.

SSGR data of Stovec Industries Ltd 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 Stovec Industries Ltd has shown very healthy growth without raising any debt.

An investor may read our complete analysis of Stovec Industries Ltd in the following article: Analysis: Stovec Industries Ltd

We can see that companies like India Nippon Electricals Ltd and Stovec Industries Ltd, which have SSGR higher than their 10-year sales growth, are able to sustain their growth without leveraging their balance sheets. In case of an 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 their plant & machinery/technology to maintain their current sales growth rate.

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

The premium that an investor might decide to pay for such companies is a personal preference; for example, a premium of an incremental PE ratio of 1 for every 5-10% cushion of SSGR over the 10-year 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, which is yet to be established by any statistical estimates).

b) If the SSGR is lower than the 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 the funds needed for investments to generate 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 growth, as their operational business is not able to generate the required amount of funds.

Let us see the examples of companies that have SSGR lower than their 10-year sales growth rate:

i) Granules India Ltd:

Granules India Ltd is a Hyderabad-based Indian integrated pharmaceutical manufacturer that focuses on making active pharmaceutical ingredients (API), pharmaceutical formulation intermediates (PFI) and finished dosages (FD) as primary business activities.

While analysing Granules India Ltd, an investor noticed that the company has been growing its sales at a rate of about 20% year on year, whereas it has an SSGR of about 10-12%.

Therefore, an investor would notice that Granules India Ltd has been growing its sales at a rate that its business model is not able to sustain. As a result, the company has to raise funds to support its growth from additional sources like debt. The total debt of the company has increased from ₹121 cr. in FY2011 to ₹892 cr. in FY2020.

An investor may read our complete analysis of Granules India Ltd in the following article: Analysis: Granules India Ltd

ii) Emmbi Industries Ltd:

Emmbi Industries Ltd is engaged in the manufacturing of technical textile products: flexible intermediate bulk container (FIBC) / various polymer-based packaging products, geotextiles, water conservation products (Aqua Sure) etc.

While analysing Emmbi Industries Ltd, an investor notices that the company has been growing its sales for the last 10 years at a rate of about 17%, whereas it has an SSGR of about 9-11%.

Therefore, an investor would notice that Emmbi Industries Ltd has been growing beyond the ability of its business model and as a result, the company has to raise funds to support its growth from additional sources like debt. The total debt of the company has increased from ₹23 cr. in FY2011 to ₹116 cr. in FY2020.

An investor may read our complete analysis of Emmbi Industries Ltd in the following article: Analysis: Emmbi Industries Ltd

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 the ongoing 10-year 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 other opportunities where companies are growing within their SSGR.

2) Free Cash Flows:

As described in the article on Free Cash Flow (FCF), we believe that FCF is the ultimate measure of the investability of any company.

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

FCF = CFO – Capex

Where,

• CFO = cash flow from operations
• Capex = capital expenditure, including maintenance capex and capital work in progress (CWIP)

Capex for any year can be calculated as the difference between gross fixed assets (GFA) & CWIP at the start of the year and the end of the year. It can also be calculated by deducting net fixed assets & CWIP at the start of the year from the net fixed assets & CWIP at the 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 shareholders. FCF 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 relatives/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 can save in future/have our job intact or not. 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 the stake of existing shareholders.

In both 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 can 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 valid just like an educational loan for an individual. An education funded by a loan is an investment that has the potential of increasing the skill set, earning ability and future wealth of a person and therefore is considered a good investment.

Similarly, for companies, investments in plants & machinery and technology are like an educational loan, which increases future earnings potential. Therefore, we should not worry about a situation where a company is not able to generate positive FCF for a few years. Such companies might be taking out education loans to generate future wealth. However, if a company is not able to generate positive FCF over long periods of time (I assessed them over the 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 cases, the investment made is not of much use.

I, as a shareholder, expect the companies I own to be cash-generating machines. Their business should be a source of cash for me and not the other way around. Therefore, positive free cash flow generation by a company over the 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 the last 10 years has been 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 a minimum amount of CFO as capex, have a significantly higher margin of safety than the companies that have used almost all CFO. Needless to say, the companies that have their capex much higher than their entire CFO over the last 10 years (i.e. negative FCF) have a 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 companies A & B generated the same amount of CFO over the last 10 years (say ₹100 cr).

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

When 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 sales growth by using only 50% of its 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 payments. Theoretically, company A can tolerate its profitability and cash collections (CFO) declining by 50% before signs of stress start becoming visible in 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 make 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 under a lot of debt burden. In the tough economic situation described above, company C would find it 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 more costly.

Companies like C are prime candidates for bankruptcy in tough times as they find it difficult to service existing debt and make payments to suppliers. Such companies, usually 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 into 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 the ongoing 10-year G-Sec yield to arrive at their ideal PE ratio.

a) Companies with Positive Free Cash Flow (FCF):

i) Paushak Ltd:

Paushak Ltd is India’s largest phosgene-based speciality chemicals manufacturer. Paushak Ltd is a part of the Alembic Pharmaceuticals group.

While analysing Paushak Ltd, an investor noticed that over the last 10 years (FY2011-20), the company has generated cash flow from operations (CFO) of ₹125 cr. whereas it needed to invest only ₹70 cr. in its business, thereby leaving ₹55 cr. (44%) in the hands of the company as discretionary cash to reward its shareholders. No wonder the company could provide dividends to the tune of ₹35 cr. over the last 10 years despite remaining debt-free.

An investor may read our complete analysis of Paushak Ltd in the following article: Analysis: Paushak Ltd

We can see that companies like Paushak Limited, which have generated positive free cash flows (FCF), can sustain their growth without leveraging their balance sheets. During tough times, such companies can reduce the prices of their products, offer higher credit periods to their customers, and pay suppliers promptly to attract and retain quality suppliers without impacting their 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 money to fund the emergency measures.

In the 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 the ongoing 10-year 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; for example, a premium of an incremental PE ratio of 1 for every 5-10% cushion of FCF% above a minimum threshold for companies that have been growing their sales above 15% per annum for the last 10 years.

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

b) 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 their inherent business strength permitted.

i) WPIL Ltd:

WPIL Ltd is an Indian company involved in fluid handling by way of making pumps and executing turnkey water supply projects for irrigation, oil & gas, power, and other industries.

While analysing WPIL Ltd, an investor noticed that over the last 10 years (FY2011-20), the company has generated cash flow from operations (CFO) of ₹427 cr. whereas it needed to invest only ₹575 cr. in its business, thereby leaving it with a negative free cash flow of ₹(148) cr.

As a result, the company has to raise additional money by way of debt. Over the last 10 years, the total debt of WPIL Ltd increased by ₹324 cr from ₹53 cr in FY2011 to ₹377 cr in FY2020.

In light of a negative FCF, an investor would also appreciate that the dividend payments of ₹31 cr done by the company to its shareholders are funded by debt, as the company has already used all its CFO to meet its capex requirements.

An investor may read our complete analysis of WPIL Ltd in the following article: Analysis: WPIL Ltd

If the economic scenario deteriorates further, then companies like WPIL Ltd would have to meet their cash requirements by raising further debt or equity. In case its lenders or shareholders do not provide this capital, then the company would face a difficult time tiding over the crisis and may resort to selling assets to repay lenders or face bankruptcy.

Looking at the above situation, it is clear that companies like WPIL Ltd do not have a significant margin of safety built into their 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 the ongoing 10-year 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 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 the higher the FCF as a 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 that 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 of a stock investor.

Advised reading: 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 an investor’s portfolio, where the investor had selected the company after doing significant research

It is a known fact that investors can make 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 criterion 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 premium. This is with the assumption that the investor has selected the stocks in her portfolio by doing sufficient research, has been monitoring the stocks continuously and is well aware of the management, business, products and markets of the companies in her portfolio.

4) Stable Business Premium:

In 2020, I analysed all 2,800 listed companies with a market capitalisation of more than ₹10 cr. (What I learnt from brief analysis of 2,800 Companies)

During this exercise, I found that large companies with strong financial performance are valued higher than small companies with strong financial performance.

I noticed that once a company crossed the ₹10,000 cr market capitalisation barrier, the market gave it a premium of about a 10-15 PE ratio. It means that if an investor finds a company with strong business growth backed by cash flow from operations and characterised by good free cash flow, which the company uses to reward the shareholders and the investor notices that it has a market capitalization of more than ₹10,000 cr, then the investor will find that its PE ratio will be about 10-15 PE more than another similar company with strong fundamental growth with free cash flow etc. but which has a lower market capitalization.

This trend of higher PE ratios for the large companies with good fundamentals seems to be the “stable business” premium that the market pays to such companies. This is because these large companies have an established business model, a much larger reach to their customers, an established sales & distribution setup and financial power to withstand the crisis. In addition, during challenging times, large companies take market share away from their smaller competitors. (Read: Financial performance of large companies shows that they are large for some reason)

It seems that when companies keep growing their business, then at some level, the market may think that the company has now surpassed the “existential threat”. It means that it is highly likely that the company would be able to survive the next crisis and come out of it alive without facing bankruptcy.

Relieving the market of “existential threat” seems to be an important barrier that large companies with good fundamentals seem to have crossed. As a result, the market rewards these companies with a “stable business” premium of a 10-15 PE ratio.

An investor may draw a few inferences from it:

First, if she focuses on the segment of large companies with strong fundamental growth and convinces herself to pay a premium of 10-15 PE ratio to buy stocks of these companies, then she can avoid many negative surprises in her portfolio during a crisis or difficult times. This may bring peace to her investing journey.

On the other hand, the investor may infer that if she finds a small company with strong fundamental growth and stays with the company when it crosses barriers like ₹10,000 cr market capitalisation, then the market, in general, will appreciate the company for its “stable business” and no “existential threat”. As a result, the market will then give this company a premium of 10-15 PE ratio, which will add a significant amount of return to her portfolio performance.

So, if an investor finds a company with a large business size that has crossed the “existential threat” barrier, then she may pay this “stable business premium” of 10-15 PE ratio to the company.

Conclusion:

With this, we come to the end of the current article, which focused on the key criteria that an investor should look at while deciding on 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 that already exist in her portfolio.

To summarise, 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 of the company. Lower interest rates/yield scenarios would lead to higher PE ratios and vice versa.
2. Competitive Advantage (Moat) enjoyed by the Company:
   • Self-Sustainable Growth Rate (SSGR): If the company has an SSGR that 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 the ongoing 10-year 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 that have SSGR much lower than the 10-year annual sales growth rate and, as a result, are growing beyond their business potential by continuously raising debt.
   • Free Cash Flow% (FCF/CFO): An investor may decide to pay a premium over the benchmark PE ratio arrived at after considering the ongoing 10-year G-Sec yield for buying the stocks of the companies that generate high free cash flow as a proportion of their cash flow from operations (FCF/CFO).
     • The investor should avoid companies that have negative free cash flows and are funding their growth/normal business operations by raising debt.
   • An investor should note that adding both SSGR premium and FCF premium may lead to double-counting. This is because companies with strong SSGR often also show positive FCF. Therefore, it may be more prudent to use either SSGR or FCF as the basis for assigning a premium, based on the investor’s understanding of the business.
3. Circle of Competence of the Investor:
   • In case the investor is not able to find any new stock that is within her comfortable PE ratio range, then she may decide to pay a small premium to invest in stocks that 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 maybe from the industry that the investor knows thoroughly about.
4. Stable Business Premium:
   • A premium of 10-15 PE ratio to large companies that have crossed the “existential threat” barrier with a large business size, an established business model, a much larger reach to their customers, an established sales & distribution setup and financial power to withstand the crisis and who, during challenging times, can take market share away from their smaller competitors.

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

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

Readers’ Queries: Price to Earnings Ratio (PE Ratio)

Should we pay high P/E for stocks with a proven competitive advantage/moat?

Dr. Malik,

I hope you are well.

I have questions regarding the valuation of a stock over the long term. I would like to use Asian Paints as an example. I am not invested; I am just trying to understand the dynamics of a long-term moat stock.

As you have taught, buying at the right price is critical to higher profits, in essence, a low PE/low PB.

Advised reading: How to earn High Returns at Low Risk – Invest in Low P/E Stocks

I am left confused by the case of Asian Paints. Over the last 10 years, Asian Paints has gone from a PE of 24 to the currently exorbitantly high 63 PE. What I find astounding is that the chart of Asian Paints PE shows a steady rise over the last 17 years, giving us a CAGR of nearly 11% for 17 years.

What I am surprised to find is that even if an investor picked up Asian Paints at a PE of 30, he or she would have still produced decent profits over the years.

Lynch says that the PE number should be about the growth rate of stock, meaning Asian Paints must produce a growth of 60%, which to my mind does not seem plausible. However, this argument would have held strong when the stock was at PEs of 30 and 40.

Therefore, I have to ask, how this is possible. Relentless growth in the PE for a company with never a reversion to the mean. What PE would be considered ludicrous for this stock? I would have thought 40 PE was too much, then 45, then 50, and now 63. It would seem that I am wrong in all of my assumptions.

How does a market left, over 17 years, this growth in the PE, even for a moat company? I know that Buffett has said that in the long term, a market is a weighing machine, but in this case, it does not seem to be the case.

I would welcome your thoughts, and if I have made mistakes in any of my calculations, I apologise in advance.

With Thanks,

Author’s Response:

Hi,

Thanks for writing to us.

We believe that when we pay a high P/E to enter into a stock (e.g. a P/E of more than 25), then a lot of things have to work in favour of the company for it to make good returns for the investor. We do not know of any precise method to left or to determine why a stock should command a P/E of 30, 45 or 60. One thing that we know is that it’s not the actual slowdown of growth, but even a perception of the impending slowdown of growth can reduce the P/E multiple of such companies and, in turn, can reduce the return of the investor when compared to the EPS growth over the holding period.

We have highlighted such issues in the following article: Hidden Risk of Investing in High P/E Stocks

So when we see the margin of safety in such investments, then we understand that the probability of negative surprises leading to reduced returns is higher when the initial purchase price is high than the case when the initial purchase price is lower.

Nevertheless, there is never only one way to look at markets and investments, and Peaceful Investing is only one way to invest in markets. Many investors have made significant returns by investing in well-known, high-growth companies at high prices. However, as discussed in the above article, we do not believe that we are able to find out what factors can affect the future of business performance/investor perception/sentiment about such companies, and therefore, we tend to stay away from them.

This is not to say that everyone should follow our approach. In fact, there is a book, “Common Stocks Uncommon Profits” by Phil Fisher, which focuses solely on such growth stocks. I have read this book and realised that I am better off sticking to finding growth at lower prices so that the odds are more in our favour.

In summary, we believe that the odds (margin of safety) are more in favour of the investor when the initial purchase price is low. However, does that mean that high P/E stocks will always lose money for investors over a selected period? No. The market is too uncertain to make such predictions.

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

In addition, as we routinely say, there would always be stocks outside one’s portfolio, which would make huge returns for other investors. Investors should be ok watching such stocks from the sidelines if they do not fit into their investing approach. The idea is to find an approach that an investor feels comfortable with and find companies that meet that approach.

Advised reading: Selecting Top Stocks to Buy – A Step by Step Process of Finding Multibagger Stocks

Hope it answers your query.

All the best for your investing journey!

Regards,

Dr. Vijay Malik

Can we determine a minimum PE ratio that a stock will always have?

Vijay sir! I read all of your topics very carefully. Great job Sir!

Please write something about how much minimum price-to-earnings (P/E) ratio a stock will command by simply seeing its net profit, sales growth, or EPS growth. To my knowledge, minimum P/E should be equivalent to EPS growth YoY.

Please throw some light on – how to determine the minimum P/E a stock must command, by seeing its fundamentals.

Some good stocks are available at very high p/e like Sequent Scientific, 8k miles, and they continue to trade at such high p/e like 300 -1400 p/e, and a company with very good fundamentals continue to trade at a very low p/e, why it is so?

Author’s Response:

Hi,

Many thanks for your positive feedback. I am happy that you liked the articles on my website.

Price to earnings ratio (P/E) is a factor that depends on many factors like the consistency of earnings, capital structure, general market sentiment, promoter’s perception, company & products’ brand image, liquid float in the market etc.

All these factors are fluctuating in nature. Out of these multiple factors, the consistency of earnings, liquid float etc., is less fluctuating, whereas factors like market sentiment, market perception etc. keep fluctuating a lot.

Therefore, assigning or predicting a P/E ratio for stocks is very uncertain. This is one of the reasons that we do not try to assign any target price or intrinsic value to any stock. We prefer to buy good stocks at a low P/E ratio, which provides the margin of safety and then trust the markets that they will take the market price higher as the consistent growth in earnings continues in future.

We advise the readers and investors to avoid predicting the P/E ratio and instead focus on buying fundamentally sound companies at a low price, i.e., a low P/E ratio, which provides a good margin of safety as discussed in the article above.

We also advise readers to avoid investing in high P/E companies as they have a lot of hidden risks, which have a high probability of impacting the returns of an investor. You may read about my views on investing in high P/E companies in the following article:

Read: Hidden Risk of Investing in High P/E Stocks

At the same time, I believe that investing in low P/E companies is a good way to create wealth in the stock market:

Read: How to Earn High Returns at Low Risk: Invest in Low P/E Stocks

I hope this clarifies your query.

All the best for your investing journey.

Regards,

Vijay

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

Author’s Response:

Thanks for the comment!

I believe in limiting myself to the P/E ratio based on historical earnings and not using forward earnings. While reading the book “The Intelligent Investor” by Benjamin Graham with commentary from Jason Zweig, I came across a section that 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 that you read The Intelligent Investor if you have not read it already. It is a very good book.

Hope it helps.

Which P/E ratio should we use: Average P/E or Current P/E?

While looking at the P/E ratio of a particular stock, should we be looking at the average P/E over a period or the current P/E?

Please advise.

Author’s Response:

Hi,

Thanks for writing to us!

It is an investor’s choice to use the parameters that she prefers and finds suitable for her investing approach. Different investors use P/E ratios based on a different set of earnings, like the last FY or last 12 months or an average of the last 3 or 5 years etc.

While calculating the PE ratio, we normally use the EPS, which is the lower of the following two:

1. average of EPS of the last 3 years and
2. EPS of the last 12 months (if the company does not have any subsidiary or the consolidated quarterly financial results are available) or last financial year’s earnings (when the company has a subsidiary/associate but does not provide quarterly consolidated financial results).

Let us see an illustration.

The first case is where a company has started performing poorly in the past 12 months.

• Suppose the current market price is ₹100/-
• The last 3 years’ average EPS is ₹10/-; therefore, the PE ratio based on the last 3 years’ average earnings is 10 (= 100/10).
• Recent poor performance has reduced the latest 12-month EPS to ₹5/-; therefore, the PE ratio based on recent 12-month earnings is 20 (= 100/5).

Therefore, in the above example, out of the two PE ratios of 10 and 20, we would assume the PE of the company as 20 while making a valuation analysis and accordingly make an opinion about the company. If, by looking at other parameters, we determine that we are not willing to pay a PE of 20 to the company, then we may skip buying it.

The second case is where a company has started performing well in the past 12 months.

• Suppose the current market price is ₹100/-
• The last 3 years’ average EPS is ₹10/-; therefore, the PE ratio based on the last 3 years’ average earnings is 10 (= 100/10).
• Recent good performance has increased the latest 12-month EPS to ₹20/-; therefore, the PE ratio based on recent 12-month earnings is 5 (= 100/20).

In such a case, out of the two PE ratios of 10 and 5, we would consider the PE ratio of 10 while making a valuation analysis. If, after overall analysis, we believe that we are not willing to pay a PE ratio of 10 to the company, then we may skip buying it.

Further advised reading: 3 Principles to Decide the Investable P/E Ratio of a Stock for Value Investors

We would not be able to comment on the criteria used by other investors.

All the best for your investing journey!

Regards,

Dr Vijay Malik

Can we use the historical PE ratio of a company to determine whether it is currently undervalued or overvalued?

Dear Sir,

You say that the industry-specific PE ratio is not relevant for investors. (Is Industry P/E Ratio Relevant to Investors?). However, what about the company-specific PE ratio for large established companies?

If a company like Infosys Limited, which has a median PE ratio of around 18 for 8 years/5 years, if we are able to buy it for say 13 or 15 PE ratio, then we can say that we have bought it cheaply relative to historic valuations and then sell it when it goes above the median PE ratio.

The investor needs to analyse the reason why the PE ratio fell before buying the stock.

This is something like the Nifty PE ratio. When the Nifty PE ratio crosses a certain threshold, we say the market is overvalued and when it falls below a certain threshold, then we say the market is undervalued.

Author’s response:

Hi,

Thanks for writing to us!

We do not give a lot of weight to the historical PE ratio. This is because, if the company is doing well and as a result, its PE ratio rises, then the PE ratio may not go down in future. Similarly, if the company is doing badly and as a result, its PE ratio comes down, then the PE ratio may not go up in future.

Therefore, we advise the investors to look at the current business position and the current PE ratio of the company and then make their decision.

3 Principles to Decide the Ideal P/E Ratio of a Stock for Value Investors

All the best for your investing journey!

Regards

Dr. Vijay Malik

What is the impact of tax on Earnings Yield, Margin of Safety, and Ideal PE Ratio?

Hi Dr. Malik,

I wanted to touch upon your article on the ideal PE ratio of the company, and one of the factors mentioned was the comparison with the interest rate prevailing in the market. Shouldn’t the comparison be PBT/market cap vis-a-vis G-Sec yield or PAT/market cap vs G-Sec yield(1-tax rate)?

Regards,

Author’s response:

Hi,

Thanks for writing to us!

Tax rates are different for different sets of investors.

• Individuals and corporations have different tax rates.
• Different individuals have different applicable tax rates as per their overall income.
• Different corporations have different applicable tax rates depending on the legal provisions
• Investment trusts, mutual funds etc. have different applicable tax rates.

As a result, we do not use tax rates in calculations. In addition, comparing pretax G-sec yield and post-tax earnings yield has an added benefit in that it makes the criteria more stringent.

However, if an investor wishes, then she may use a tax rate in the comparison.

All the best for your investing journey!

Regards,

Dr Vijay Malik

What are the impacts of the Market PE ratio and Industry PE ratio on the PE ratio of individual stocks?

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

What were the debt (ratios) considerations when you took these stocks? When a company is reducing debt by restructuring or other processes, 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 the P/E ratio also depends on the industry and the state of the market. Say the average P/E of the FMCG industry would be higher than that of the mining industry. However, within the 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 on Jan 31, 2014).

Therefore, I believe that in any industry at any given point in 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 that 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 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 and strictly screens every stock on the parameters, she would be able to differentiate a good company from a 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.

My investment philosophy is to gain from P/E expansion, which happens when fundamentally good companies growing at a good rate are discovered by market participants post my purchase. I can find such companies in the sub ₹500 crores (₹5.00 billion) market capitalisation 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 good learning for all of us.

Follow-up Query:

Hello Vijay,

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

I always give preference to dividend-paying companies as they tell much about management (you already mentioned all this in your articles). I don’t limit myself to a limited number of stocks as far as I can get a fair price 🙂 ONGC, HPCL, BPCL, IOC, ITC, and HUL all were available at fair prices in 2012 when the market was hovering around 5500… I increased positions in all of them during that time. I can’t compare the 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 the 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 a little late in entering into finding these growth companies as 2008-2013 was a 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) for now and will be holding it for the 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 the 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 at different times. Happy for you!

Congratulations on 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 too late to enter the market because the time spent in the market is the most important factor that influences returns. The best time to invest is now. The future is bound to show corrections, and if an investor can maintain her buying habits, then she might get good stock at discounted prices in future as well.

Nice to have your input 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 investment decision. It would be a pleasure to read about your experience and investing strategy.

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

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Disclaimer

This article was originally written and published during the period when I, Vijay Malik, was registered with SEBI as an Investment Adviser. I am currently registered with SEBI as a Research Analyst (Regn. No. INH100008364).

This article is for educational purposes only and should not be construed as investment advice or a recommendation to buy or sell any securities. Investors should do their own research before making any investment decisions.

I, or my immediate relatives, do not have any financial interest in the companies discussed as on the date of publication of this article, nor do we hold one per cent or more of the securities of such companies at the end of the month immediately preceding it. I do not have any material conflict of interest and have not received any compensation or other benefits from the companies or any third party in relation to this article during the 12 months preceding its publication. I have not served as an officer, director, or employee of the subject companies, nor have I been engaged in market making activity for them.