The ratio of discontentment - the PE ratio

My framework for the PE Ratio.

The PE ratio.

No discussion about markets is ever complete without bringing in the word “PE” in the conversation. It may be the PE of the market that bothers you or the PE of a stock but this word always remains a source of bother.

If you really like a company it will always have a PE ratio that’s too high for your liking.

If the PE ratio is too low, you will question if the numbers are cooked or am i missing some angle here.

This is what we start our market journey with but never really understand it even after a few decades in the market.

My understanding of PE.

The first thing we need to understand about the PE ratio is that it’s a short-hand or a rule of thumb to get a quick temperature check on the valuations. It is not as important as it is made out to be and it should NOT be the most important variable in your decision about whether to buy or sell a stock. In fact it should be just one variable. A lot of times we just look at the PE ratio first thing and if that number is too high we just move on and don’t even bother to understand what the company really does and what the earnings profile is.

We basically give it way too much importance, in fact we equate PE to value. This leads you to miss out on huge opportunities. If you look at your own past you would have either not bought or sold many names too early because the PE looked too high.

So lesson number 1 is - PE is NOT equal to Value. It is a shorthand for value and unless you break it down it is often very deceiving.

Balance.

Everything in nature has a balance. Yin and Yang. Shiv and Shakti. Everything has two sides and the same is true of the PE ratio.

PE is one side and there are several factors on the other side. Absolute PE makes no sense. A PE of 50 can end up being cheaper than a PE of 20. You should always ask why is the PE what it is, what are the factors on the other side of the equation and then see if it is justified or not.

Lesson number 2 is - Figure out why the PE ratio is what it is. Find out the reasons behind it before making a judgement on whether it is overvalued or undervalued.

The other side.

There are several factors that may decide the eventual PE ratio but i would break them down into the below key ones.

1. Growth - what i mean by this is the medium term growth outlook. This is the most important factor and probably has a 50% or more weightage to what the PE ratio is likely to be.

2. Sector - this is the neighbourhood the stock lives in. The PE ratio of other stocks in the sector (high or low for whatever reason) has a bearing on the PE ratio for our stock.

3. Lineage - Enough said.

4. Leadership - if you’re a sector leader or number two player you will have a higher PE ratio if all the other factors are the same. However even if you are a low rung player but have a significantly higher medium term growth outlook you will have a higher PE ratio. That’s why i said earlier that growth trumps other factors. It’s like a veto on everything else.

5. ROE/ROCE - This is what determines quality of growth.

   1. if the growth if low but the ROE/ROCE is high you’ll get a higher valuation

   2. if the growth is super high but ROE/ROCE is not great - doesn’t matter much

   3. If both the growth and ROE/ROCE is high - you’re in goldilocks zone.

6. Longevity of growth - If your growth can be projected far into the decade you’ll have a high PE. Think Avenue Supermarts, Nestle etc. Ofcourse they enjoy some of the other factors too which aid to keep the PE ratio high.

7. Cashflow - Markets inherently don’t like companies with negative or low operating cash flow vs the accounting profit. Till such time the growth is high this can be ignored but once growth starts to falter - this factor comes back to bite very bad. This in no way means one should only buy companies with high positive operating cash flows. Some of the biggest winners have been the ones with negative operating cash flow -but this is something we need to understand - that it doesn’t matter until it suddenly does.

8. Cyclicality/Turnarounds - These are the PE distorters. You’ll see this is the commodity businesses - they will trade at PE of 2/3/5 at the peak of their cycle and trap a lot of first time benjamin graham readers. Similarly companies which are just turning around will have absurd PE ratios that you will need to dig deeper to make sense of.

9. Popularity - If the stock belongs to a hot theme you get extra brownie PE points. This happens as people throw caution to the winds in FOMO or YOLO or other four letter acronyms.

10. New Category - Markets love new categories. Something new that the market has taken fancy to will always have a high PE. Of course by definition these new categories demonstrate high growth which aids the PE but markets love the idea of something new. This is typically most IPOs in a new sector.

11. Float - Eventually markets are all about demand and supply - if the float is low you’re likely to have a tailwind to your PE ratio. Explains a chunk of the PE ratio for the MNCs.

So we have our equation.

PE ratio = growth + roe/roce + sector + lineage + leadership + cashflow + longevity + cyclicality + popularity + float + new.

This equation will help you make sense of the PE ratio much better. Once you start seeing it as an equation and not an absolute number - things will make much more sense. You may still not be comfortable buying a 60 PE stock but at least you know why it’s at 60 PE.

Also if you find something where a lot of these factors are lining up and the stock is at 20 PE then you know you may just have a winner on your hands.

Let me also try to give a priority to these ratios in order of importance:

1. Growth profile - without a doubt is numero uno.

2. Sector + Longevity

3. Popularity + Newness + Float

4. ROE/ROCE + leadership

5. Lineage + Cashflow

6. Cyclicality

This is just indicative. Don’t @ me.

Best returns come from high PE stocks.

This is a reality that many of us can’t digest. But just randomly pick up any date and look for the stocks with the best 3/6/12 month performance and you will see 60-70% of them will have high or absurd PE ratios. Let me just do that and pick the best 3 month performers now:

Look at the PE ratios - most of them are what we would typically label as high or absurd. Some don’t even have a PE ratio. If we’re overly dependent on this ratio then we leave a lot of money on the table. This makes it all the more important to learn to dissect this ratio of discontentment.

Conclusion.

Best performers often have a high or absurd PE ratios. So it’s important to understand how this PE ratio emerges to participate in them.

PE ratio is a rule of thumb. Don’t give it too much importance.

Don’t take PE ratio at face value or in absolute terms. Its an equation, appreciate the other side of the equation.

The actual equation of course - refer to it whenever you can’t make sense of a PE ratio. Let me know if i’ve missed any important variable.

Thank you for reading.

PS: Leave a comment if you want me to talk about something specific in future posts. Your comments are invaluable to decide what to write about.