Classroom | Cheap or expensive: How to value a stock (Equity: Part 8)

The absolute price of a stock is no indication of whether a stock is cheap or expensive. Its valuation depends upon different measures, the most popular of which is the price to earning or P/E multiple.

Kunj Bansal

October 10, 2019 / 16:37 IST

In Part 8 of the Classroom, we delve into how to value stocks and what analysts mean when they say a stock is cheap or expensive.

A market expert says that stock X, which is trading at Rs 200, is cheaper than stock Y in the same industry, which is trading at Rs 50. I am confused.

The absolute price of a stock is no indication of whether a stock is cheap or expensive. Its valuation depends upon different measures, the most popular of which is the price-to-earning or P/E multiple. ‘P’ here is the current market price of the stock and ‘E’ is the earnings per share.

I understood price, but what is earnings per share?

Say a company has 10 lakh shares in issue, which are held by different classes of shareholders—promoters, institutions, retail investors. If the company makes a net profit of Rs 50 lakh, then the earning per share will be Rs 5. (Rs 50 lakh divided by 10 lakh shares)

How does one look at P/E?

The rule of thumb is that a stock with a low P/E ratio is cheap while the one with a high P/E is expensive. In the above case, the P/E for the Rs 200 stock might be lower and therefore, it is being called cheaper.

Does this mean that a stock with low PE multiple is always a good buy and that a stock with high PE multiple should be avoided?

Wish it were that simple! Then, making money in the stock market would have been very easy. No, it doesn’t mean that. P/E basically tells you how much worth is being seen in a stock by the market. A stock trading at higher multiple is considered better quality, generally. In other words, a good quality stock will always command a high P/E.

An investment decision in a stock depends upon a lot of other factors. Sometimes the market assigns a low P/E to a stock for a good reason. It could be anything from unscrupulous promoters, mediocre product line, lack of pricing power, among others.

Your job as an investor is to understand whether you agree with the market's assessment on whether the given P/E is right.

Are PE multiples standard across different sectors?

They are not. P/E multiples depend upon the broad financials and earning capability of a sector. A consistently-performing, less cyclical, higher margin and high growth sector will always command higher multiples as compared to say, a commodity sector where earnings keep moving up and down.

Is PE multiple the best indicators to tell if a stock is cheap or expensive?

No. There are other indicators such as Price/Book Value (P/B), Enterprise Value (EV)/Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA), Discounted Cash Flow (DCF), Dividend Discount Model (DDM) to name a few. Their applicability depends upon the business of the company. For instance, P/B multiple is commonly used to evaluate companies in the banking, financial services and insurance sectors.

A stock has fallen 50 percent from its record high. Does that make it cheap?

No. One will have to look into the reasons for such a sharp fall and then take a call.

Sometimes stocks fall sharply because some big fund house(s) may be exiting. The selling may or may not be related to the company’s fundamentals. Sometimes, it could be that the fund is facing redemption requests from its investors. At other times, the reason could be something more serious like the management having fudged the financial statements or done some shady dealing.

Conversely, a stock has doubled in price. Does that automatically make it expensive?

No. If a company’s earnings has grown 100 percent during a period, the stock’s P/E ratio will be the same even if its stock price has doubled.

So, doubling of the stock price doesn’t necessarily mean that it has become expensive. Of course, if the stock price has doubled without any visible improvement in the company’s operating performance, then the stock may be considered expensive.

I have heard market experts always talk about forward P/E. What does that mean?

That means that the earnings being used for calculation is for the period that is yet to come. Say the stock of a company quoting at Rs 100 had reported an earning per share of Rs 10 last year. Based on that EPS, the stock is trading at a P/E multiple of 10 (Rs 100/Rs 10 per share). If the company is expected to double its EPS to Rs 20 in the current year, then based on the expected EPS of Rs 20, the stock is quoting at a P/E multiple of 5.