How to use the PE Ratio to Find Multibagger stocks

The PE ratio (Price to Earnings) is a popularly known financial metric used by many investors the world over. It is a robust financial metric if used correctly. Many successful value investors realize that they have limited time and energy. Therefore they use financial ratios like the PE ratio as part of their checklist, to scan for stock picking opportunities.If you want to become a better investor; a good understanding of the PE ratio is critical.

Now, I have tried to make this article as simple as possible for you.

However, if you have any doubts, make sure you ask questions in the comments section.

Read this article over and over, till you grasp the concept of the PE ratio correctly. Intelligent investing requires effort, without effort nothing is possible!.

If you who are already familiar with the PE ratio, you may find the initial part of the article quite simple. Please take the liberty to move forward. It is important for me to be as simple as possible for beginners.

How to use the PE Ratio to Find Multibagger stocks

 

In this article, you will learn the following:

  1. How to use the PE ratio to find and invest in multi-bagger* stocks (last section of the article).
  2. How to calculate the PE Ratio of a company.
  3. How to calculate the Expected return from PE ratio.
  4. How to adjust PE for growth rates/ estimate growth adjusted PE Ratio.
  5. How to analyze the impact of positive and negative events/news on stock price using the PE ratio.
  6. How to avoid or sell overpriced stocks using the PE ratio.

*Note: A multi-bagger is a stock which gives returns of more than 100%. However, over a long-term horizon, a return of 21.6% compounded has been achieved by Warren Buffet who is world’s greatest investor. If you invested1000 INR at 21.6%, you would be worth 17.64 million or 17.64 lakhs or 1764 times in 50 years time.

Significance of the PE Ratio

 

To understand the meaning and importance of the PE ratio, you must understand one fundamental fact about investing in shares:

“When you buy a stock of a company, it is not a piece of paper or an electronic ticket; you are buying a small part of the business as an owner.”

Thus the PE ratio stems from two questions an intelligent investor should ask himself before investing:

  1. How much profit does this company earn?
  2. And at what price should I buy the stock of this company to get a good return?

When you turn on your TV or visit the Bloomberg website, you will find different prices for different companies. The share price of some companies may be in single digits and some maybe in multiples of thousands per share.

How do you know which stock is cheap to buy? And which you can sell at a higher price? The PE ratio is a tool used by many investors to solve this problem.

The PE ratio takes NET PROFIT of a Company and compares it to its STOCK PRICE.

For example:

Company A has a stock price of 100 and earns a Net profit of 20 per share (EPS).

Company B has a stock price of 20 and makes a Net profit of 1 per share (EPS).

Which stock is cheaper?

At first impression, a stock price of 20 for Company B looks more reasonable compared to 100 per share for company A.

Now, if you take the Net profit per share of Company A into consideration; you will realize the following:

For Company A the return would be 20/100 = 20%, and

For Company B the return would be 1/20 =5%.

Thus company A would be a better investment and cheaper stock as it is earning a 20% return for investors.

Understanding the PE Ratio

 

It is quite simple to calculate the PE Ratio of a company. The formula to calculate the PE Ratio is as follows:

PE ratio = Stock Price per share/Earnings per share (EPS)

Where EPS or E = Net profit /total shares outstanding.

P = Stock price of the company.

*Note: You can easily find the required data to calculate PE Ratio on NSE/BSE stock exchange or Bloomberg website.

 

Example:

The stock price of Company A is 100 today, and it has EPS of 5 then the PE Ratio = 100/5 = 20.

Remember, Lower the PE cheaper is the stock and a better investment.

Now, let’s take a closer look.

Impact of stock price on PE Ratio

 

The stock price is the numerator in the PE ratio equation. The stock exchange sets the stock price or Price per share and keeps changing every day.

Thus, the PE ratio is constantly changing as the stock price of a company is never constant due to changes in business environment and news events.

Example:

The stock price of Company A is 100, and it has EPS of 5 then the PE Ratio is 100/5 = 20.

The stock price of Company A drops to 80, and it has EPS of 5 then the PE Ratio is 80/5 = 16.

The stock price of Company A rises to 120, and it has EPS of 5 then the PE Ratio is 120/5 = 24.

Thus, assuming the EPS is constant,

Remember Lower the stock price lower is the PE ratio and higher the stock price higher is the PE ratio.

Earning per share

 

The Earnings per share (EPS)  is the denominator in the PE Ratio equation.It is the per share net profit of the company you are considering for investment.

EPS = Net profit for the year / Total number of outstanding shares*.

*The total number of outstanding shares are the shares issued by the company. You will find the above information in the company’s annual report or stock exchange website.

The key question you need to ask yourself is that does the earning per share change? 

The answer is Yes.

However, the earnings per share (EPS) changes slower than the stock price.

But, it does change !, and this, in turn, affects the PE ratio.

Example:

  1. Company A has a Stock price of 100, and it has EPS of 5 then the PE Ratio is 100/5 = 20.
  2.  If Company A has a Stock price of 100, and its EPS drops to 4, hen the PE Ratio is 100/4 = 25.
  3. If the stock price of Company A is 100, and its EPS rises to 8, then the PE Ratio is 100/8 = 12.5.

If Net profits of a company increase then the earning per share will grow, and it will result in a lower PE Ratio.And, If profits of a company fall then the EPS will fall and it will lead to a higher PE Ratio. 

Calculating Expected rate of return

 

Now that we have a good grasp of the PE Ratio and it’s two components lets see how you can use it to make better investing decisions.

Investing is a zero-sum game, and there is always an opportunity cost. You can invest your money in many ways, and we need to use the PE ratio to help us find the best stock for investment. Warren Buffet has said that “Investing is best when its business like.” To compare investments, you need to calculate the Rate of return you will get.

To calculate the Rate of Return, you need to reverse the PE ratio to get an expected rate of return.

                                       The Rate of Return = EPS / Price of the Stock.

For example: If the price of Company A is 100 today and it has EPS of 5 then the EPS/Price = 5/100 = 5%.

A government bond of India or fixed deposit will give you a tax-free return of close to 8%, so that will be our base.

Therefore, the minimum rate of return we require is 8%.

To have given an investor a 8% return, the PE Ratio of a company would have to be 12.5 or below.

Remember that whenever you look at the PE ratio which is Price/ Earnings per share.

Reverse it! – Earning per share / Price; this will give you the expected rate of return.

Zero Growth Company/Returns

 

As an investor, you must bear in mind that an expected rate of return of 8% is a zero growth company because the fixed deposit or government bond will not grow its return over the business years.

This is why you will find that some companies on the stock market are trading at a high PE ratio, and some are trading low PE ratio.

If a company is going to be stable and not grow its Earnings per share (Net profit) at all ( 0% growth) and its expected rate of return is higher than 8% ( PE Ratio lower than 12.5) than it is worth considering buying the stock.

 The Growth-Adjusted PE Ratio

 

The reasons for higher and lower PE ratios is different expectations for each company from the market for growth in profits. For example, if a company is in high-growth consumer business it may have a PE of 30 compared to a public sector bank having a PE of 15.

For example: If a company is in high-growth consumer business it may have a PE of 30 compared to a public sector bank having a PE of 15. The reason for this difference is an expectation of growth in profits and EPS (earnings per share).

Now let’s incorporate growth or increase in expected rate of return for this we need to adjust the PE Ratio for growth in EPS. I have adapted the below formula from Benjamin Graham’s Intrinsic Value formula in his book The Intelligent Investor.

Growth Adjusted PE Ratio =( PE Ratio /(Zero growth PE Ratio + Growth Rate of EPS ) ) * PE Ratio.

Now allow me to give you an example.

For example: Say a company has an EPS of 10. The price is 150. You have estimated the growth rate for next 5-7 years at 10% per year.

The Normal PE Ratio would be = 150/10 = 15 and expected return would be 10/125*100 = 6.66%.

A return of 6.66% is not good to consider making an investment if it was a zero growth company. Becuase the rate of return is below 8%, and PE Ratio is higher than 12.5

Now, observe what happens when we incorporate a 10% growth in Earnings per share of the company.

Growth Adjusted PE Ratio = (15 / 12.5 + 10) * 15 = 0.545 * 15

Growth Adjusted PE Ratio  =8.11              

Note*- 12.5 is zero growth PE Ratio

Thus due to the growth rate of 10%, you would get an actual growth Adjusted PE Ratio which is lower than 12.5 and expected return would be 1/8.11 = 12.22% which is higher than 8%. It will be worth considering buying this stock.

That’s great! Keep following me, and let’s now analyze the impact of Increasing EPS and  Declining EPS using our formula, so you understand the PE Ratio better.

Let us Continue with our Example of Company A:

EPSCurrent PriceZero Growth PEReturn on Investment
1015012.58%

Company A has PE Ratio = 150/10 = 15

Impact of Increasing EPS on Growth PE Ratio

Now you will now be thinking about the scenario in which the EPS is growing let’s see what happens to the Growth Adjusted PE Ratio.

Normal PEEPS Growth RateGrowth Adjusted PEExpected Return
15512.868%
151010.0010%
15158.1812%
15206.9214%
15256.0017%
15305.2919%
15354.7421%

As you can see, there is clearly a positive relationship between your estimated growth and your expected return on investment.

Also, there is a negative relationship between EPS growth and Growth adjusted PE suggesting that the stock is cheap at the market price.

Impact of Declining EPS on Growth PE Ratio

 

Now let’s have a look at the scenario in which the EPS and profits are falling and understand the impact on the Growth Adjusted PE Ratio.

Normal PEEPS Growth RateGrowth Adjusted PEExpected Return
15512.868%
15315.007%
15018.006%
15-322.504%
15-530.003%
15-845.002%
15-1090.001%

As you can observe in the table above as the EPS growth rate declines the growth adjusted PE ratio rises suggested that the stock is expensive at the current price levels.

Also, there is a positive relationship between EPS decline and expected rate of return indicating that the stock is expensive at the market price if EPS declines or registers a degrowth. As growth declines the expected rate of return also declines.

To sum up the previous two sections so far we have established the follow

  1. Price and EPS are the factors that affect the PE ratio and Expected return.
  2. Low Price = Low PE ratio which makes the stock attractive.
  3. Growth in EPS causes the PE ratio to be lower and Expected return to being higher
  4. Lower the  Growth Adjusted PE Ratio more attractive is the stock.
  5. A decline or de-growth in EPS causes the growth adjusted PE to be higher.

Before we discuss, how you as an investor can use the P./E ratio to make better investing decisions. We need to take an, even more, a closer look at the EPS and Price in unique situations as it can create opportunities for an investor.

The Impact of News and Events on the PE ratio

 

The stock price and EPS of a company change over time. One of the main factors affecting this is when more news about the company, economy and government policies comes out. These factors may or may not influence the profitability of the business you are analyzing.

When you see some news about a company or government policy affecting a particular sector you need to ask yourself the following questions.

  1. Will this affect the net profits of the company in the long term or the short term?
  2. The impact of News or information is positive  or negative ?

Short-term (6-12 months) Impact of News

 

After analysis, if your answer is that the impact is of short-term nature and it won’t occur again in the coming years to affect the company. Then you need to ask yourself two more questions.

  1.  Will this news impact the company positively or negatively?
  2. If it is going to impact the short-term profits negatively.. will the company be able to recover from the loss?

Now you can classify the news event on the company in 3 categories.

  1. Positive short-term impact on net profit.
  2. Negative short-term impact on net profit and company will survive/recover.
  3. Negative short-term impact on net profit and company will go bankrupt/financial problems.

Negative short-term impact on net profit and company will survive/recover

 

An example of this would be a fire in one of the factories affecting production in a particular year, till operations get back to normal. The “factory fire” event would result in a company reporting a lower net profit for that year. A lower net profit would mean a lower EPS and Higher PE ratio.

Here is an example.

Company ACurrent YearAdjusted for One-time loss
Year
Gross profit130130
One time Exceptional loss – Due to Factory Fire/Shutdown-400
Net profit90130
EPS4.56.5
Current Stock price100100
PE Ratio22.2215.38
Growth Adjusted PE Ratio17.968.61
Expected Return5.57%11.62%
Outstanding shares20.0020.00
Expected EPS Growth rate15.00%15.00%

A higher PE  or growth-adjusted PE ratio, in this case, would create an optical illusion of the stock being too expensive.

To see through this namely, you need to add back the one-time loss to the net profit and adjust the EPS. In the example above we added the -40 one time loss and counted the net profit as 130 instead of 90. The result of this adjustment was a lower growth PE at 8.61 versus 17.96 and higher expected return at 11.62% vs. 5.57%. We adjusted the Net profit because this was a one-off event and short-term in nature. Once the company resumes operation in the coming year and the EPS stabilizes to the previous level the PE and Growth adjusted PE will return to lower levels, and the stock will appear attractive or cheap. The trick is to hold your nerve as a value investor and let things play out.

Positive short-term impact on net profit

 

Similarly, a positive short-term event would have a reverse effect on EPS. An example of this would be the sale of land or an asset in a particular year. This sale has nothing to do with operations or the core business of the company. The “Sale of Land event” would result in the company reporting a higher net profit for the current year, and this, in turn, would mean a higher EPS and Lower P/E ratio.

Here is the example.

Company ACurrent YearAdjusted for One-time Profit
Year
Gross profit100100
One time Exceptional Profit- Due to Sale of Land/Asset300
Net profit130100
EPS6.55
Current Stock price100100
PE Ratio15.3820.00
Growth Adjusted PE Ratio8.6114.55
Expected Return11.62%6.88%
Outstanding shares20.0020.00
Expected EPS Growth rate15.00%15.00%

A lower PE  or growth-adjusted PE ratio, in this case, would also create an optical illusion of the stock being cheap.

Just like we did before, to see through this anomaly, in this case, you need to subtract the one-time profit to the net profit and adjust the EPS. In the example above we added the 30 one time profit and counted the net profit as 100 instead of 130. The result of this adjustment was a higher growth PE at 20 versus 15.38 and lower expected return at 6.88% vs. 11.62%. We adjusted the Net profit because this was a one-off event and short-term in nature. Once the company resumes operation in the coming year and the EPS stabilizes to the previous level the PE and Growth adjusted PE will return to higher levels, and the stock will appear expensive.

The trick is to hold your nerve as a value investor and let things play out. Thus short term events can help you identify investment opportunities if the stock price falls, PE is low, and EPS or net profit is only affected in the short term.

Negative short-term impact on net profit and company will go bankrupt/financial problems

 

In the event of news of which will cause short-term loss to the company and company won’t be able to recover from it financially. Then as an investor, it makes little sense to do a PE ratio analysis, the best course would be to stay away or short the stock if the PE is too high.

Long-term (3-5 years) Impact of News

 

After analysis, if your answer is that the impact is of Long-term nature and it will continue to occur again in the coming years and affect the company. Then you need to ask yourself two more questions.

  1. Will this affect the company to improve, deteriorate or maintain its  Net profits? Yes or No
  2. Will it influence the long-term net profit margin positively or negatively? And why ?.

Based on your answer to the above two questions. You can now classify the news or event in two categories.

  1. Positive Long-term impact on net profits.
  2. Negative Long-term impact on net profits.

Long-term positive impact on PE Ratio

 

An example of this would be lower taxes on the sector. A lower tax rate on the sector your company is operating in will increase the net profits for next 5-7 years. Whenever such a new surfaces you need to adjust an increase in your expected EPS growth rate.A higher expected EPS growth rate would result in a lower growth adjusted PE Ratio.

Here is the example: Government announces 10% reduction in taxes for cigarettes. Company A sells cigarettes.

Company ACurrent YearAdjusted for Drop in tax by 10%
Year
Gross profit100100
00
Net profit100100
EPS55
Current Stock price100100
PE Ratio20.0020.00
Growth Adjusted PE Ratio14.5510.67
Expected Return6.88%9.38%
Outstanding shares20.0020.00
Expected EPS Growth rate15.00%25.00%

In this case, you need to increase the Expected EPS growth rate upwards; this will result in lower Growth adjusted PE ratio. In the example above we added the 10% to Expected growth rate and counted the Expected EPS growth rate as 25% instead of 15%. The result of this adjustment was a lower growth adjusted PE at 10.67 versus 14.55 and higher expected return at 9.38% vs. 6.88%. We adjusted the Expected EPS Growth rate because lower taxes will be beneficial to long term profits of the company. Once the benefit of lower taxes kicks in, in the coming years, the EPS will rise resulting in a fall in PE ratio, and the stock price will go up as it will appear cheaper.

Long-term negative impact on PE ratio

 

Similarly, a negative long-term event would have a reverse effect on net profits.

An example of this would be an increase in some competitors or price wars in a particular year. High competition and price wars would result in the company reporting a lower net profit in the coming 5-7 years due to price wars, and this, in turn, would mean a lower EPS and higher Lower PE ratio making the stock unattractive. To adjust for this event, you need to revise you expected growth in EPS to lower levels.

Here is the example: A new competitor enters in the telecom sector announcing lower tariff plans. Company A is a telecom operator.

Company ACurrent YearAdjusted for Drop in tax by 10%
Year
Gross profit100100
00
Net profit100100
EPS55
Current Stock price100100
PE Ratio20.0020.00
Growth Adjusted PE Ratio14.5522.86
Expected Return6.88%4.38%
Outstanding shares20.0020.00
Expected EPS Growth rate15.00%5.00%

In this case, you need to decrease the Expected EPS growth rate downwards; this will result in higher Growth adjusted PE ratio. In the example above we subtracted the 10% from Expected growth rate and counted the Expected EPS growth rate as 5% instead of 15%. The result of this adjustment was a higher growth adjusted PE at 22.86 versus 14.55 and lower expected return at 4.38% vs. 6.88%. We adjusted the Expected EPS Growth rate because more competition will be detrimental to long term profits of the company. Once the adverse effect of higher competition and price wars kicks in, in the coming years, the EPS will fall resulting in a fall in PE ratio, and the stock price will go down as it will appear expensive.

Price and EPS Interplay: Finding a Multibagger using PE Ratio

 

Now, that you have understood the intricacies of EPS and Impact of news flow on price, Let us move ahead.

To find multi-bagger stocks which will multiply over the coming years, It is crucial to know what happens to the stock price when some news comes out.

To help you understand what happens in a real-life scenario and interplay between price and eps.

Here is case example.

Example 1: Company A operates in the steel sector. The price of the stock is 100; Net profit is at 100, EPS of 5 and PE ratio of 20. After analyzing the company and sector, you have decided that the expected growth in EPS is 20%. The growth adjusted PE ratio is at 12.31, and expected return is 8.13%.

News: The next morning you are faced with the news that there is a fire in one out of the five factories of the company and the company will face a one-time loss of 20.

Post event impact!

 

The stock price plummets by 10% and falls to 90. Estimated Net profit falls from 100 to 80 because of a one-time loss of 20. EPS will be 4 and PE ratio at 25. The expected growth in EPS is 20% and remains unchanged at this event won’t affect the long-term profitability or growth of the company. The growth adjusted PE is at 19.23, and expected return is 5.20%.

After adjustment

 

As we discussed before, because the impact of the event is one-time and short-term in nature, we will add it back to the one-time loss of 20 to the estimated net profit which will make it 100. The price is 90, and the EPS will be 5. The new PE will be 90/5 = 18. he expected growth in EPS is 20% and remains unchanged at this event won’t affect the long-term profitability or growth of the company. The growth adjusted PE is at 9.97, and expected return is 10.03%.

Because the expected return is at 10.07% which is higher than the zero growth of 8%. You decide to invest at 90.

Here is how it will play out in the next five years.

YearCurrent Year12345
Gross profit100120144172.8207.36248.832
One time loss-2000000
Net profit80120144172.8207.36248.832
EPS467.28.6410.36812.4416
Current Stock price90120144172.8207.36248.832
PE Ratio22.52020202020
Growth Adjusted PE Ratio9.9712.3112.3112.3112.3112.31
Expected Return10.03%8.13%8.13%8.13%8.13%8.13%
Outstanding shares2020.0020.0020.0020.0020.00
Expected EPS Growth rate2020.0020.0020.0020.0020.00
Return on investment Yearly33.33%30.00%30.67%32.60%35.30%
Total Return176.00%
Total Yearly return35.00%

After the year of one-time loss. The gross profit of the company grows at 20% per year. Thus in year one, it becomes 120 all the way to 248. The net profit also increases to 248 as the one-time loss of -20 is non-recurring.

The increase in net profits causes the EPS to trend upwards, and you will see it grow at 20% in line with the net profit becoming 12.4 at the end of the 5th year.

As seen in the table above if the company grows its profits at 20%; we can assume that the PE will be at 20 which was the case the year before the event. A PE of 20 gives us a growth PE of 12.5 which is zero growth PE. The expected the return is close to 8%.

Assuming this we will get a Stock Price = PE ratio * EPS.

In Year 5 the stock price of Company A should be 20*12.4 = 248.

Company A will give you a total return of 176% in 5 years and a Yearly return of close to 35.20%.

Conclusion

 

The PE ratio is a handy metric/tool when used with expected profit growth rates. The PE give you an estimation whether a company is overvalued or undervalued. It can help you to identify and buy cheap stocks however it is far from a complete tool. There are many things which it ignores, and one needs an excellent understanding of the underlying business of the company in which you are contemplating an investment. It does not take into consideration Return on Capital employed, Management background, future potential of the company, cash earnings, cash flow, assets, and business cycles.

As a thumb rule, you should never make investment decisions just on the PE ratio; However, the PE ratio does have use in investment decision and should be part of your thinking process as an intelligent investor.

Please feel free to ask any questions or requests you may have below.Keep following me.

 

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