If you are in Egypt, you have to think like an Egyptian. If you are in Greece, you have to think like a Greek. But, if you are in a stock market, you need to think like both the Greeks and the Egyptians. Johnny believes that much of the stock market talk sounds like some Egyptian mystery spoken in Greek. Today, he is trying to understand the mystery of price-earnings multiples.
Illustration: Jayachandran/ Mint
Jinny: Hi, Johnny! I see you are engrossed in a book so early in the morning. What’s the matter?
Johnny: Well, Jinny, I am engaged in serious business. I am reading a book that promises to teach Greek in 30 days.
Jinny: But, why are you learning Greek? Are you planning to go to Greece for a vacation or something?
Johnny: No holiday. I was just trying to figure out whether our stock market talk has any link with Greek. Otherwise, why do we hear about such complicated things as price-earnings multiples?
Jinny: No need to learn Greek when you just want to understand something as simple as price-earnings multiples. If you put your book aside, I could tell you about it in a few minutes.
Johnny: Go right ahead.
Jinny: The price-earnings, or P-E, multiple is one of the most common indicators we use to judge the worth of a company’s shares.
Most commonly, people watch stock market indices such as the Sensex or Nifty to understand whether the market is rising or falling. But, stock indices do not tell the full story. That is why investors also keep a watch on the P-E multiples to understand whether the rise or fall is justified by the earning prospects of the company. The P-E multiple tells us how many times the earnings per share we are paying for purchasing the shares at the present market price. So, for calculating P-E multiples, we need to know two things—the present market price of the shares and the earnings per share, or EPS.
Getting the present market price quoted at the stock exchanges is easy, but calculating EPS requires some exercise.
Johnny: What exercise? I don’t think it could be tougher than learning Greek in 30 days.
Jinny: For calculating EPS, you first need to know the net earnings of the company. Analysts generally take the net earnings from the most recent four quarters, or 12 months, to calculate what is known as trailing EPS.
However, some analysts use the projected earnings to calculate what is known as forward EPS. Trailing and forward P-E multiples can be calculated by using trailing and forward EPS, respectively. For the sake of simplicity, here we are referring to past earnings only.
Once you have the net earnings figure, you need to subtract the dividend that is payable to preference shareholders and divide the result with the number of outstanding equity shares to get EPS.
For instance, if the net earnings of a company after paying preference dividend is Rs1 lakh, and the total number of equity shares is 10,000, then EPS would be 10.
Companies report the EPS figure in their income statements. Once you know EPS, you can calculate the P-E multiples.
Jinny: Yes. You need to just divide the present market price of the shares with EPS.
If the present market price is Rs200 and EPS is 10, then the P-E multiple would be 20. That’s it. But, what does it tell you? If you look at the P-E multiples like an investor, you will understand that for purchasing a share that is earning Rs10 every year, you’re paying a price that is 20 times its earning.
So, the higher the gap between the price and the earnings, the higher the P-E multiple. That’s why people call stocks that have higher P-E multiples overvalued, and those with lower P-E multiples, undervalued.
Johnny: Tell me, at what level of P-E multiple is a stock neither overvalued nor undervalued?
Jinny: Now, that’s a tricky issue. Some shares with higher P-E multiples may still be undervalued and some at even low levels may be overvalued. It all depends upon the company you are looking at.
As a thumb rule, you need to compare the P-E multiple of the company with that of peer group companies in the same sector or industry. But, this may also not give you the true picture if the sector, as a whole, has been overpriced by the market.
In case the present looks surreal, you can look at the historic figures of the P-E multiples of the same company to see whether the present is in sync with the past. If you are still not sure about the true level, then learning a little bit of stock market Greek may help you understand the market talk of experts about true levels.
Johnny: Thanks, Jinny. I will try to learn stock market Greek. But, I am surely wiser now after talking to you.
What: The P-E multiple is one of the indicators of valuation of shares being traded in stock markets.
How: The P-E multiple is calculated by dividing the market price of the share by the value of the earnings per share.
When: Higher P-E multiples may indicate overvaluation and lower P-E multiples, undervaluation.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at email@example.com