June 22, 2016

Why Looking at P/E Ratio to Buy a Stock is Not a Good Idea?

The P/E ratio is highly revered by investors.

It has acquired almost a cult-like status among the pantheon of financial metrics and ratios that are commonly used.

However, looking at P/E ratio to buy a stock may not be a very good idea.

The P in the P/E ratio refers to the stock price.

And as we know stock price fluctuates throughout the trading hours and across the trading days, at times showing extreme volatility.

So which price should ideally be taken as P?

Using value of P based on any consideration is not appropriate. P/E ratio can be made to swing wildly depending on what value of P is chosen!

The E in the P/E ratio refers to EPS (Earning Per Share).

Again EPS can be calculated in various ways.

EPS can be based on latest quarter, latest year, average of last "n" quarters, average of last "n" years or some arbitrarily chosen time period.

The above is not very helpful.

An alternative approach would be to take quarter-wise EPS for the last 3 years (basically last 12 quarters) and calculate exponentially weighted average EPS.

Let is call this EW-12Qtr-Avg-EPS.

In case EPS for any quarter is less than zero, it should ring the alarm bell very noisily. In such a case buying a stock may not be a very good idea. Even  EPS should not be computed.

Assuming non-zero EPS in the last 12 quarters, the EW-12Qtr-Avg-EPS can be calculated.

To be on the safer side the minimum of EPS in the last 12 quarters can be taken.

Let us call this Min-12Qtr-EPS.

Now, suppose the goal is to earn a certain percentage return, say R%.

In that case, the stock price which will allow R% returns to be made can be calculated as:

P <= (EW-12Qtr-Avg-EPS) / R

or P <= (Min-12Qtr-EPS) / R

The second equation is more conservative and hence will provide higher margin of safety.

The side effect will be that many more stocks will fall outside the "buy-able" zone as compared to the case when first equation is applied!

P in the above two equations is the maximum price that can be paid to purchase the stock so that returns are >=R%

Let us take an example.

Suppose EW-12Qtr-Avg-EPS for company A is USD 10. Also suppose the investor wants to earn 10% return (over the long-term horizon).

In such a case, the stock purchase price should be less than USD 100.

The higher the price above the above amount, the lower the returns will be.

Note - Inverse of P/E is also called as Earnings Yield (E/P). A simple look at E/P ratio can easily show that as P goes up earnings yield goes down!

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