One of the most common mistakes made by new investors is not understanding what all goes into making a PE ratio.
With everyone wanting to hold a company with lowest PE ratio, it is essential to note that PE is also one of the easiest ratios that can be manipulated via creative accounting, changing accounting policies, creatively spreading or consolidating expenses & earnings.
Let us take an example – Say a company called ABC Corp is has EPS of 5 rs and trading at price of 100. So PE for ABC Corp. is –
PE = 100/5 = 20.
At PE of 20, it simply means it’d take 20 years of cumulative earnings to arrive at a current market price.
And, that is why investors want to invest in companies with lower PE ratios – Eventually should take lesser time to arrive at a cumulative earnings at current market price.
What about growth?
However, one of the biggest danger of using PE or Industry PE to filter stocks is – It does not factor in growth. Let us take an example.
For e.g. Avenue Super-marts (DMART) was trading at a whopping PE of 150 in Q3 of 2017. That translates to cumulative earnings of 150 yrs to justify market price of 900 rs. Makes sense? No!
Precisely for this reason, a lot of pundits, financial advisory, broking houses, and financial analysts denied to invest in the company. But price kept on moving, why? Nobody factored in the growth.
DMART was growing at a rapid pace, and while looking at a PE, it was important to understand whether there is any scope for EPS expansion. Many investors missed this point.
As expected, DMART posted fantastic results, and its EPS doubled. That translated into PE getting halved! As per recent data, DMART now trades at a PE of 75 from previous 150.
This is no way a recommendation to buy or sell a said company or its stock.
But, it is important to notice that if EPS continues to grow at same pace for next year, at EPS of 30, PE would fall to 40! Noticing how we are coming down from 150 to 40?
Creative Accounting – The other side of the PE
Another important point that many investors miss, or perhaps are not aware that companies can creatively manipulate expense and earnings to manage a PE ratio. Let us understand from example –
Again, ABC Corp. is an online service provider that sells content such as songs/videos to subscribers. A subscriber would pay a fee to consume the content. Something similar to Netflix.
Now, suddenly ABC Corp. decides to normalize its subscription revenue from a monthly to yearly. That means, they would consider future revenue into current quarter and this would impact PE directly. As earnings are inflated, PE falls.
What happens if subscribers do not renew their subscription after 4 months?
Another aspect to look at this is managing expenses creatively.
Let us say, ABC Corp. is a software provider and provides services to manage consumer on-boarding. Its client would want that ABC Corp. incurs initial expenses of deploying hardware & software. As ABC Corp wants to grow, it agrees to incur expenses upfront. However, it knows that client would pay going forward, and ABC Corp shows entire expense into the quarter that was incurred, they would be forced to show huge expense, and it’d impact investor sentiments. It would also mean earnings would fall, and PE goes sky rocket.
So, to manage this creatively, ABC Corp. decides not to show entire expense in one quarter. Instead, it spreads the expense evenly into all 4 quarters. Eventually client would pay, and things would be sorted out. No Fret!
In both of these above situation, ABC Corp effectively manipulated its PE. While investors who did not give due diligence to what goes into arriving at a PE ratio, would invest based on what is shown to them and fall into trap. Invest at wrong price, and get stuck
Do not do this mistake. Always remember, investing purely based on a PE is not a good idea.