Stocks with a lower PE are considered reasonably valued as their growth potential is still untapped whereas higher PE signals an over-priced stock.
There is one thing which investors will not leave hunting for and that is ‘value’. Equity investors are always on a lookout for stocks which are trading at fair or below valuations compared to long-term averages.
Price-to-earnings multiple is one of the measures which can be used to scan stocks trading at attractive valuations. It is one of the widely=used value indicators for stock investment and is perceived as an important indicator for long-term investment decisions.
A scan of BSE 500 stocks threw as many as 164 companies which are trading at a discount to their 5-year average PE including names like Swan Energy, Jubilant Life Sciences, Century Textiles, BEML, Magma Fincorp, Ashok Leyland, etc., according to data from AceEquity.
(Note: Stocks mentioned are for reference and not buy or sell ideas)
The general rule of the thumb is — stocks with a lower PE are considered reasonably valued as their growth potential is still untapped whereas higher PE signals an over-priced stock.
However, analysts beg to differ. For long-term investment decisions, investors should use more than one valuation parameter to select stocks rather than just looking at one, because PE ratio is not an isolated indicator of valuation.
“A stock trading with lower P/E in comparison to industry or their average certainly offers a proposition for value hunt, but apt cost is something that investors should study upon. Even though short-term challenges can be overlooked but overall business should have sustainability in terms of revenue generation in a longer timeline supporting the investment objective,” Dinesh Rohira, Founder & CEO, 5nance.com told Moneycontrol.
“Investment in this stock should be supported by fundamental factors, like pharma space is witnessing a momentum after several setbacks on foreign regulatory front and pricing pressure,” he said.
On the other hand, nearly 300 stocks in the S&P BSE 500 index are trading above their 5-year average which includes names like Indiabulls Ventures, Infibeam Corporation, L&T Infotech, Tejas Networks, Shoppers Stop, JK Tyres, Titagarh Wagons, etc.
“Price-to-Earnings doesn’t always depict true potential of a stock, although it is a legitimate indicator of valuation. Investors have to weigh in several factors related to a particular company; a rigorous quantitative and qualitative analysis is required to be done before selling a particular stock,” Ashish Sharma of Guiness Securities told Moneycontrol.
Are all the stocks trading below average PE buy ideas?
Stocks which are trading below their 5-years average PE might have value proposition but can we say that they are all top buys? That may not be the case.
In the current market scenario, any company with high growth rates and increasing return ratios are trading high PE ratios. PE is not always the right measure to pick stocks. The best way to decide whether to buy a stock on PE basis, is to match with other parameters, suggest experts.
“Not all stocks that are trading at less than 5-year average PE are worth betting on. Among the names mentioned, pharma stocks have seen challenges from multiple segments and hence the growth visibility is less,” Pankaj Karde, Head-Institutional Sales, Systematix shares, and stocks, told Moneycontrol.
“Due to lower visibility of growth, the stock trades at lower PE ratios. Also, on the other hand, APL Apollo has grown significantly faster. With improving margins and growth rates beating industry, improving return ratios, the stock looks a great buy,” he said. “If a stock has been trading at lower than average multiples and also providing great growth prospects, it’s a blinder,” added Karde.
What should investors do?
For generating long-term wealth it is clear that PE ratio alone should not be the sole decider of your stock selection. Are there any other parameters which one can count on?
There are plenty of other parameters explained by experts which could come in handy in deciding stocks for long-term investment.
“PE ratio is not an isolated indicator of value buy. It is integral to perform an extensive research of the company, before investing. Factors like identifying the undertone of the markets, interpretation of macros at large specifically the geo-political tensions, the domestic scenario is required,” Ashish Sharma of Guiness Securities told Moneycontrol.
“SWOT Analysis of individual companies and a diagnosis of the financial health as well as the other factors should be thoroughly done before chipping in the hard earned money,” he said.Karde of Systematix shares and stocks said that the best way to decide whether to buy a stock on PE basis is to match with other parameters. “If a company is generating free cash flows consistently, have been growing upwards of 20 percent CAGR and is in a non-cylical industry, I would go ahead and make a decision to buy, even if the stock is expensive on PE basis,” he said.