It is not rare for investors to get attracted to a stock trading at less than Rs 100 levels or at times below Rs 20-30. The assumption is that such stocks are undervalued.
The truth may be different. A stock trading at Rs 150 can be cheaper than a stock priced at Rs 15. This is because stock price reflects not only the company’s past performance but also its ability to generate revenue, its competitive edge and the efficiency with which its uses resources.
To find a stock’s real value, one has to look beyond its price at certain ratios.
Price-to-earning (P/E) ratio: This most common indicator of a company’s value is arrived at by dividing the stock price by average earning per share (EPS) during a past or future period. It shows how much you have paid for the stock for every rupee earned against the stock or is likely to be earned.
Let’s take the example of Indiabulls Power and NTPC, both power generating companies. On November 26, Indiabulls Power was trading at Rs 11.11, while NTPC was trading at Rs 159. If you go just by the price, the NTPC stock is 13 times expensive than the Indiabulls Power stock.
However, in the trailing 12-month period, each Indiabulls Power share has earned just Re 0.02 or 2 paise, while each NTPC share has earned Rs 12.57. On November 26, Indiabulls Power was trading at 464 times its past 12-month earnings while NTPC was at 12.66, clearly showing that the Indiabulls Power stock is much more expensive than that of NTPC.
However, a better indicator is the price-to-estimated EPS ratio. To calculate it, the price is divided by the expected EPS in, say, the next financial year. Doing this gives an idea about how the stock is priced in view of its expected performance.
The P/E ratio is relative and does not tell the complete story on its own. One should compare a company’s P/E ratio with that of industry peers, the index it belongs to and its own long-term average to arrive at any conclusion.
“Just because the P/E ratio throws up some value doesn’t make the stock cheap or expensive. It just gives a relative idea and can be used to dig deeper into the reasons the stock is cheap or expensive than peers,” says Raunak Onkar, head of research, asset management, Parag Parikh Financial Advisory Services.
Price-to-book value (P/BV) ratio: This tells us how a stock is priced vis-à-vis the assets on the company’s books. Numerically, it is the stock price divided by its book value. Book value is assets minus liabilities of the company. Consider the JSW ISPAT Steel stock, which ended November 26 at Rs 9.75 and was trading at 122 times book value, way higher than peers—Tata Steel (priced Rs 371, trading at P/BV of 0.68), Uttam Galva Steel(priced Rs 58.45, trading at P/BV of 0.68), Jindal Steel (priced Rs 372, trading at P/BV of 0.43).
However, if a stock is trading below its book value (P/BV less than one), it may not necessarily mean it is undervalued. It could mean that either the company’s assets are overstated or it is not using them properly. If the former is true, it is better not to invest, as there will be a correction in asset prices and hence the stock price. The latter favours investors as a good management has the potential to rev up the stock in such a scenario.
A high P/BV may not always mean the company is overvalued. It could also mean that it is earning very high returns on its assets.
It is, therefore, important to look at P/BV in the context of other ratios such as return on equity(RoE).
Return on Equity (RoE): This is net profit after payment of dividend on preferred stock divided by shareholder equity. RoE is expressed in percentage and tells us how much profit the company has made using shareholder money.
Usually, an RoE of 15% or more is considered good. “If it’s less than 15%, see if there are triggers that can push it beyond this level,” says Ravi Shenoy, assistant vice president, mid-cap research, Motilal Oswal Securities.
Here too, compare the average long-term (three-five years) RoE of companies in the same industry to see whether the company you are looking to invest in is more efficient in generating profits than others.
A company with low P/E or P/BV will be a value pick only if it has been posting decent RoE over a long period. A company may have low P/E or P/BV ratios because it is not generating good earnings.
RoE can be misleading at times as it does not take into account the debt part of assets.
Consider two companies with the same asset size (Rs 5,000 crore) and the same profit (Rs 500 crore). Company A has Rs 2,000 crore shareholder equity and Rs 3,000 crore debt. Company B, on the other hand, has Rs 2,000 crore debt and Rs 3,000 shareholder equity. Therefore, Company A’s RoE is 25% as against Company B’s 17%. This shows that a high-debt company may at times show a higher RoE.
Ratios such as dividend per share to price (2% or more) and dividend per share to EPS also establish if a company with low P/E and P/BV ratios has potential.
“Rising payout (dividend per share/EPS) with good dividend yield (dividend per share/share price) is even better. This indicates management confidence that it can grow in the future without much capital,” says Ravi Shenoy of Motilal Oswal Securities.
A stock’s value is not gauged by its price alone but depends on its ability to give higher returns in the future. The ratios mentioned above help us take a more conclusive view of stock valuations.