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Why not to shun stocks with higher PEs?

Why not to shun stocks with higher PEs?

Have you been avoiding buying stocks with high PE? The turbulent times we are currently going through may push us in many different directions. And one such inclination may be to shun high PE stocks to safeguard your wealth and investment. However, that may not be the best idea, and here is why.

What is PE?

The PE indicates the willingness of investors to pay per rupee of earnings. While a low PE would mean investors aren’t ready to pay a higher price to buy a stock, a high PE multiple would indicate the contrary. 

The daunting question for investors buying high PE stocks —Are we paying too much than the value of the stock? Particularly during slow economic growth, this fear takes over the investor sentiment. According to expert financial advisors, though with the lagging earnings growth, it may seem like a wrong decision to buy these stocks, there are strong reasons to reconsider that notion.

Is Cheap, always the Best?

Imagine visiting a vegetable market where 2 vendors are selling tomatoes at different rates. The first vendor is selling tomatoes at Rs.25 per kg, while the second vendor is offering tomatoes at Rs.10 per kg. Would you blindly buy the lower priced tomatoes? Obviously, you would want to check the quality of tomatoes. If the lower priced tomatoes are rotten, you would rather buy the higher priced ones, as you are willing to pay a higher price for Quality. What if a third vendor is selling imported tomatoes for Rs.100 a kg? You may agree that the quality is good, but the price is not worth it. The same thought process holds good for stocks as well.

The same goes for stocks.  Stocks command a higher PE if there is perception of they being qualitative better. For example, the TCS stock may have a higher PE than a new IT firm, ABC Infotech Ltd. However, if a stock is at a very high P/E, say 100, then you want to get into details of why the stock has such a high P/E.

Avoid the trap of Market PE 

Market PE can be a good indicator of whether the market is in a bull frenzy or completely in the grip of bears. It is best used by conservative investors who want to invest in Index funds. For example, if the Nifty P/E is between 12 to 14, it may indicate a buying opportunity. Nifty PE of 30 could indicate a sell.

However, Market PE and stock PE are two different things. Therefore, don’t make a stock decision based on market PE. If you have been staying away from a few stocks because of the market PE ratio, it may be time to reconsider, as indices don’t provide equal weight to  all shares and to  all industries equally. Market PE is indicator of overall market valuations, as indicated by an Index, not of specific stocks.

The valuations of stocks are heavily based on historical valuations. Even when PE of the index is close to historical high levels, it necessarily doesn’t mean that all stocks are overvalued. You need to look at the isolated stock PE rather than focusing on market PE.

Map the economic cycle

PE ratio is future-centric and tries to paint a picture of forward-looking valuations. Nevertheless, one of the factors that affect the value of the stock in the future would be the economic environment. 

Though a stock has higher PE, macroeconomic conditions and economic policies of the government may improve the market condition from what it is today. This notion is especially factored in the prices of the stocks, which have better visibility of earning faster than other uncertain ones. 

The dynamic nature of the markets can take its course very fast. Multiple factors may bring significant changes in the short term. Some of these factors include news, events, liquidity flows, and external influences.

Future Earnings 

Apart from the economic cycle, the company business itself might have some opportunities that can result in increase in its earnings in the years to come. For example, let’s say the Price of a stock is Rs.50 and its EPS (Earnings per Share) is Rs.1. This means the P/E ratio is 50, which looks very high. However, let us say this company has discovered a new drug, or has bagged a new contract, which is likely to increase its EPS in the next year to say, Rs.2.50. It means, the stock which is looking expensive at P/E of 50, will look reasonably priced at a P/E of 20 one year from now. (20 is the one year  forward P/E)

Focus on Sustainability

It is all relative! The valuation depends on each company. Where a 15 times PE multiple can seem like an appropriate price for a company’s stock, a 10 times PE for another company may be an overvaluation. Hence, a stock should be able to provide steady earnings in the long term. Apart from the company’s stable performance, you also need to consider the economic conditions that would affect the stock value.

Look at PEG ratio

WE have now understood that low P/E stock is not necessarily cheap, while a high P/E stock need not be expensive. So, is there a way to determine if a high P/E stock can still be bought? The solution lies in PEG ratio. PEG ratio is calculated by dividing P/E ratio with the growth rate of earnings of the company. EPS Growth rate can be calculated by looking at future earnings estimates. Looking at historical growth rates may not provide the right picture.

To Summarize

As lower PE is not necessarily always good, a high PE shouldn’t be the reason for you to shy away from the stock. PE is only one of the factors that is considered to arrive at whether or not a stock can be bought. . Therefore, keep an open mind and look at all the aspects while you create a systematic investment strategy.

Happy Investing!
Jamā Wealth