The purpose of writing this blog is to help readers to know some valuable insights about the most misused tool in the financial services industry- Price to earnings ratio. Ratios act as an important substitute to gain an understanding of business and triangulate qualitative aspects with quantitative aspects of the business. The importance of P/E ratio is unprecedented and is integral for the valuation of businesses.
Defining P/E ratio
What is a P/E ratio? It is a mathematical ratio where the numerator is the price of the business and denominator is the earnings of the business. Inverting P/E ratio is basically the earnings yield of business. A business valued at 100 and earning 5 is having an earnings yield of 5% or P/E ratio is 20.
Factors affecting the P/E ratio.
1. Management pedigree,
2. Return on capital employed,
3. Free cash flows,
4. Operating history,
5. Size of the opportunity,
6. Growth rates and sustainability of earnings,
7. Amount of debt in business are some of the factors affecting P/E ratio.
P/E ratio is directly correlated to the market expectations of earnings of a business and sustainability of earnings. That is the reason why an industry such as FMCG would get a higher price to earnings ratio because the visibility of future earnings is more because the business is less prone to disruption compared to a technology company where disruption is more.
Shareholder returns are the product of earnings growth and price to earnings multiple expansion and contraction. While multiples assigned to earnings of the business are strongly driven by optimism and pessimism of market cycles and wisdom of the market, earnings growth potential, the sustainability of earnings and integrity of management can be fairly estimated depending upon the quality of research.
Magic sauce for wealth creation- P/E expansion
P/E expansion refers to an increase in the P/E multiple of business due to a change in the fundamentals of business or simply market expectations. Similarly, P/E contraction refers to decrease in P/E multiple of a business and are also called P/E re-rating or de-rating. Quality of businesses matters for creating long term wealth because a good quality business can mend a bad balance sheet
while a bad quality business can destroy a good balance sheet. There are a lot of cases where an excess of debt with deteriorating business has destroyed good balance sheets. Debt brings fragility in businesses and increases the chances of failure of the business.
In conclusion, for the creation of long term wealth, one should focus on the quality of business rather than P/E ratio. Page industries, HDFC bank, Eicher Motors, Asian paints, TTK prestige are some of the examples of good quality businesses where they have grown their earnings year on year. But remember, mean reversion is a natural phenomenon, optimism is followed by pessimism and pessimism by optimism, paying a higher P/E ratio for a good quality business always has a risk of P/E contraction which can lead to price consolidation or even loss of capital.