PE ratio and how to use it to identify opportunities

There are a lot of fund managers/investors who feel that PE is not relevant. They often advocate other complex indicators. I do agree that price to earnings (PE) ratio cannot be used for decision making, but it can still be used to get a sense of the valuation.

Knowing what to move can provide you an edge

The PE ratio is the market price of the stock divided by the past 12 months of earnings. Often people use future earnings to calculate the expected PE of a stock. I prefer using trailing numbers because they are actual.

If we reverse the ratio, we get the price of the stock as PE multiplied by earnings.

“Over the long term, it is hard for a stock to earn a much better return than the business which underlies it earns. For example, if the business earns 6% on capital over 40 years and holds it for that 40 years, you’re not going to make much different than a 6% return even if you originally buy it at a huge discount. Conversely, if a business earns 10% on capital over 20 or 30 years, even if you pay an expensive-looking price you’ll end up with a good result.” - Charlie Munger

Over the long term, the stock return will match its earnings growth. However, in the short-term and medium-term PE growth or de-growth can impact the stock price return.

Stock Return = Earnings Growth + PE growth

In 2020, a lot of healthcare companies saw a moderate increase in their earnings, but a massive increase in their PE. The stock price skyrocketed in a short span. However, the same set of companies had their price beaten down in 2022 when the market became more realistic.

Similarly, in 2021, a lot of start-up funding happened at a certain valuation. Since start-ups usually don’t have any earnings a lot of this valuation was driven by market narrative. However, in 2022, a lot of these start-ups saw a decline in their valuation. Market expectations were reduced and PE de-rated.

Now how can this be used to identify opportunities?

I will use the analogy of Mr Buffet that each business can be classified as a great, good or gruesome business. A simple way to identify these businesses is by looking at return on equity, RoE. Good and great businesses will command RoE of more than 15% per annum, and there would be consistency around that. A gruesome business will find it hard to earn a good RoE, often less than the cost of capital.

One of the ways of identifying opportunities is to look at the share price increase (Good or Great Businesses) and compare it with the earnings growth. For example, if the share price has increased by 20% per annum and the earnings have increased by 40% per annum during the same period, there is a chance of PE growing.

The opposite also holds good. If the share price has increased by 50% per annum over five years but the earnings have increased by only 10% pa. The market expects the company to grow its earnings at a phenomenal rate but the company is not growing at that rate. Sooner than later the market will realise it and there is a chance of de-rating i.e. share price declining. However, if the company continues to grow its earnings, the share price may hold or grow further.

If you can identify a company that is growing its earnings, but the same is not reflected in stock price, there is a chance of PE re-rating or PE growing.

A snowball effect is created when earnings growth is combined with PE re-rating. This is often the reason why a stock price may rise a 100/200% in a short duration. A smart investor will prepare himself or herself to capitalise on such a situation.