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The Mythical P/E Ratio

P/E ratio is one of the most popular parameters among stock market investors who believe in fundamental analysis. Investors assume higher the P/E value, lower the chances of growth and lower the P/E, higher the chances of growth. In our investigation we found it is a myth rather than reality.

P/E stands for Price by EPS (Earnings per shares). As long as EPS is constant and all companies in purview have the same health, conclusion based on P/E ratio will be meaningful. Let me explain this by example. Two companies ‘A’ and ‘B’ performed identically and they generated same profit for each stock (say Rs.10). At present, stock of company ‘A’ is trading at Rs.100 per share while ‘B’ is trading at Rs.120. Assuming that next year again both companies are going to perform similarly then it means that if the investor is going to put Rs.100 with ‘A’ or Rs.120 with ‘B’ both are going to yield Rs.10 only. Of course, it makes sense for the investor to go and buy company A’s stocks.

In reality, two companies are never identical even if they are showing the same EPS. A company which might have invested in some advance machinery installation and has reduced the EPS in the current financial year has brighter chance to perform in coming years. On the other hand another company might have overused its current setup which needs significant maintenance (or replacement) in coming years or the company's sales team might have sold the goods with false promises to customers due to unreasonable sales target pressure. Sales team is on the way to leave the company and customers are going to crib about the product and services in near future. It means good EPS is about to turn bad.

We have illustrated the above hypothesis in the following table


Company A B C
Stock Price(March’12) 120 100 80
EPS (March’12) 10 10 10
P/E(March’12) 12 10 8
Management Actions & Events During financial year 2011-12, company has invested in advance machinery installation which is going to start production next year.

Company has also spent significant money on employee skills enhancement training program.
Not any significant action or event. Over burned sales team is now leaving the company. Production department is in stress (because sales team has made unreasonable promises about feature and quality to customers). Customers are cribbing about gap between promise and delivery.
EPS (March’13) 12 10 8
Stock Price (March’13) 150 100 60
P/E (March’13) 12.5 10 7.5


Above table is showing on March’12 , company ‘C’ appeared more lucrative to buy from P/E perspective while ‘A’ was the least (because all of them had the same EPS). Probably, big investors who were well informed about the management actions and events had already valued company ‘A’ on higher side. Decision made by big investors is showing that ‘A’ is less lucrative (due to high price).

Ultimately, management actions and events were reflected in terms of EPS. By the end of 2012-13 ‘C’ performed less than previous year while ‘A’ performed better than previous year. Better EPS means better price of the stock. Industry standard benchmark is showing P/E value at 10 (represented by event & action neutral company ‘B’). In spite of the fact that company ‘A’ is at P/E ratio 12.5 (above benchmark) then also investors are ready to pay more to ‘A’. Now, investors have less confidence in company ‘C’ and it is mapped with price matching to P/E ratio 7.5 (below benchmark).

We verified the above theoretical concept with real data. In our verification process we selected BSE200 stocks from 6 leading sectors. Then we selected top 5 and bottom 5 performers (during financial year 2012-2013) in those sectors. We have also tabulated the value of P/E recorded during start of financial year 2012-13. Following tables have summarized our findings.

Sector: Banking & Finance
Stock ID Name P/E (March'12) P/L(March'12-13, %)
532498 SHRIRAM-CITY UNION FINANCE LTD. 9.87 74.18
533519 L&T FINANCE HOLDINGS LIMITED 18.38 69.8
531807 ING VYSYA BANK LTD. 12 60.67
532720 MAHINDRA & MAHINDRA FINANCIAL SERVICES LIMITED 11.49 47.9
500034 BAJAJ FINANCE LIMITED 8.46 44.79
500106 IFCI LTD. 5.6 -34.17
534091 MULTI COMMODITY EXCHANGE OF INDIA LTD 24.2 -32.78
532480 ALLAHABAD BANK 5.12 -30.95
532885 CENTRAL BANK OF INDIA 20.49 -29.73
531213 MANAPPURAM FINANCE LIMITED 4.48 -29.32


Sector: Power
Stock ID Name P/E (March'12) P/L(March'12-13, %)
500134 ESSAR OIL LTD. 0 47.67
500870 CASTROL INDIA LTD 27.7* 22.3
500312 OIL AND NATURAL GAS CORPORATION LTD 9.61 20.78
500547 BHARAT PETROLEUM CORPN. LTD. 20.16 13.26
532514 INDRAPRASHTHA GAS LTD. 17.97 11.31
532939 RELIANCE POWER LIMITED 105.32 -46.64
500390 RELIANCE INFRASTRUCTURE LTD 7.84 -42.82
533096 ADANI POWER LIMITED 0 -39.64
532627 JAIPRAKASH POWER VENTURES LIMITED 26.4 -34.51
532779 TORRENT POWER LIMITED 8.03 -31.48


Sector: FMCG
Stock ID Name P/E (March'12) P/L(March'12-13, %)
532432 UNITED SPIRITS LIMITED 23.49 239.47
532424 GODREJ CONSUMER PRODUCTS LTD. 28.2 63.09
500676 GLAXOSMITHKLINE CONSUMER HEALTHCARE LTD. 34.1* 56.18
531162 EMAMI LTD 25.7 50.79
500875 ITC LTD 31.73 36.35
500825 BRITANNIA INDUSTRIES LTD. 41.58 -7.15
500043 BATA INDIA LIMITED 20.05* -7.09
500790 NESTLE INDIA LTD. 46.18* 1.91
500830 COLGATE-PALMOLIVE (INDIA) LTD. 1.52 11.55
500696 HINDUSTAN UNILEVER LTD. 36.5 13.05


Sector: Information Technologies
Stock ID Name P/E (March'12) P/L(March'12-13, %)
511431 VAKRANGEE SOFTWARES LTD. 210.29 124.33
532281 HCL TECHNOLOGIES LTD 21.26* 68.74
532755 TECH MAHINDRA LIMITED 20.29 50.72
532540 TATA CONSULTANCY SERVICES LTD. 22.51 34.06
526881 FINANCIAL TECHNOLOGIES (INDIA) LTD 6.69 5.91
532129 HEXAWARE TECHNOLOGIES LTD. 10.16* -20.84
526299 MPHASIS LIMITED 12.08* -4.54
532466 ORACLE FINANCIAL SERVICES SOFTWARE LIMITED 20.2 -1.09
500209 INFOSYS LTD 20.47 1.7
507685 WIPRO LTD. 24.28 2.38


Sector: Minerals, Metals & Transports
Stock ID Name P/E (March'12) P/L(March'12-13, %)
500008 AMARA RAJA BATTERIES LTD 11.92 89.97
517334 MOTHERSON SUMI SYSTEMS LTD. 23.85 64.48
505200 EICHER MOTORS LTD. 37.8* 36.94
500520 MAHINDRA & MAHINDRA LTD. 14.78 26.22
500290 M.R.F. LTD. 6.07* 21.05
513599 HINDUSTAN COPPER LTD. 80.33 -65.18
532234 NATIONAL ALUMINIUM CO. LTD. 17.42 -39.17
500113 STEEL AUTHORITY OF INDIA LTD. 11.4 -34.13
532286 JINDAL STEEL & POWER LTD 24.18 -33.76
500493 BHARAT FORGE LTD 21.54 -31.01


Sector: Pharmaceuticals
Stock ID Name P/E (March'12) P/L(March'12-13, %)
532300 WOCKHARDT LTD 35.68 413.19
524494 IPCA LABORATORIES LTD. 15.41 58.19
532531 STRIDE ARCOLAB LTD. 44.91* 55.42
532296 GLENMARK PHARMACEUTICALS LTD 32.45 51.9
524715 SUN PHARMACEUTICAL INDUSTRIES LTD. 36.27 42.24
500660 GLAXOSMITHKLINE PHARMACEUTICALS LTD. 42.14* -2.13
532321 CADILA HEALTHCARE LTD. 24.31 0.41
500124 DR. REDDY'S LABORATORIES LTD. 34.1 3.98
500359 RANBAXY LABORATORIES LTD. 0 5.3
532523 BIOCON LTD. 19.89 17.58
*P/E value has been intrapolated from previous and forward years results


We can clearly see, stock price growth and P/E have no evident co-relation. In fact in most of the cases low P/E ratio companies have performed worst while often better P/E companies had done better than other companies in their sector.

Conclusion: P/E parameter is not a silver bullet tool to invest. It is one of the parameters from fundamental analysis school, which is much larger than this one attribute. So, investors who are investing based on P/E ratio are under false sense of security that their investment will perform better.


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