PE ratio and it's applications


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Price per earning ratio is very simple and important metric to decide whether any stock is fairly valued or not. The project PE ratio and it's application has been done by MBA student under my guidance.

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PE ratio and it's applications

  1. 1. Deepak Doddamani TABLE OF CONTENTS1) INTRODUCTION 41.1) OBJECTIVES OF STUDY 4 1.1.1) PRIMARY OBJECTIVES 4 1.1.2) SECONDARY OBJECTIVES 41.2) NEED FOR STUDY 41.3) SCOPE OF THE STUDY 51.4) REASEARCH METHODOLOGY 5 1.4.1) TYPE OF RESEARCH 5 1.4.2) SOURCE OF DATA 5 1.4.3) TOOLS FOR ANALYSIS 51.5) BASIS FOR SELECTION OF COMPANIES 52) BACKGROUND 72.1) STRUCTURE OF BANKING INDUSTRY IN INDIA 72.2) LIST OF BANKS IN INDIA 8 2.2.1) Central Bank in India 8 2.2.2) Nationalized Banks 8 2.2.3) Old Private Sector Banks/Societies 9 2.2.4) New private sector banks 92.3) Banking Sector companies under study: 10 2.3.1) State Bank of India (SBI) 10 2.3.2) HDFC Bank 10 2.3.3) ICICI Bank 10 2.3.4) Punjab National Bank (PNB) 10 2.3.5) Canara Bank 102.4) OTHER DATA ABOUT BANKING SECTOR 112.5) Life Science companies 12 2.5.1) Pharmaceutical industry in India 12 2.5.2) Top 20 Pharma Companies in ‘Life Sciences’ category in India : 122.6) Life Science Companies under study: 13 2.6.1) Ranbaxy Laboratories Limited 13 2.6.2) Cipla Limited : 13 2.6.3) Lupin Ltd 13 2.6.4) Sun Pharmaceutical Industries 13 2.6.5) Wockhardt Ltd 13 1
  2. 2. 2.6.6) Biocon Limited 133) METHODOLOGY 153.1) LITERATURE REVIEW 15 3.1.1) INVESTMENT 15 3.1.2) ANALYSIS OF STOCKS 16 3.1.3) FUNDAMENTAL ANALYSIS 17 3.1.4) FINANCIAL RATIOS 18 3.1.5) WHAT IS P/E RATIO ? 19 3.1.6) FACTORS WHICH INFLUENCE THE PRICE/EARNINGS RATIO 19 3.1.7) Components of PE Ratio 20 3.1.8) Types of EPS 21 3.1.9) GROWTH OF EARNINGS 23 3.1.10) HOW TO INTERPRET P/E RATIO? 24 3.1.11) Concepts related to P/E 25 3.1.12) PROBLEMS WITH P/E RATIO 26 3.1.13) P/E ratios in India during 1990 and 2005 27 3.1.14) APPLICATIONS OF PE ratio 283.2) DATA & OBSERVATIONS 29 3.2.1) PE Ratios of Banking Sector Stocks 29 3.2.2) Determination of P/E values of ‘Banks’. 31 3.2.3) Determination of P/E ratio values of ‘Life Science’ companies: 323.3) ANALYSIS and INTERPRETATIONS 33 3.3.1) DATA ANALYSIS & INTERPRETATIONS of BANKING SECTOR STOCK: 34 3.3.2) DATA ANALYSIS & INTERPRETATIONS of LIFE SCIENCES SECTOR STOCKS: 343.4) SUGGESTIONS: 354) CONCLUSIONS & RECOMMENDATIONS 384.1) CONCLUSIONS: 384.2) RECOMMENDATIONS: 385) LIMITATIONS 40BIBLIOGRAPHY 2
  4. 4. 1) INTRODUCTIONEvery one of us have some ‘financial goals’ and understanding of ‘necessity of investments’.Investment in Capital Markets is quite confusing. It is very important to understand thatwithout gaining basic knowledge about ‘Share Market’ investors should not take risk ofinvestments in highly unpredictable and volatile market. Which stocks to buy? Which tohold? And which stocks to sell? The decision making process of investor is based on somesolid facts, some historical data, some predictions, some gut feelings and some tips fromexperts. Time plays crucial role in investment decisions. At what price to enter and at what price toexit from any company stock is as important decision as which stocks to buy. Long positionshould be taken when we expect share price to go high and in bear situation we short theequity. Human have some inherent tendencies like greed, fear, restlessness which also affectour BUY-SELL decisions. Diversification of portfolio is important to reduce risk. Hencesector wise understanding of market is also crucial aspect of selecting stocks.Analysis of stocks can be done using some decision making tools. PE ratio is one of thesimple metric which most of the investors, consultants and institutions use in their investmentrelated decisions. So we need to understand the importance of P/E ratio and its applications.1.1) OBJECTIVES OF STUDY1.1.1) PRIMARY OBJECTIVES To study the concept of Price Earnings ratio To study the applications of P/E ratio1.1.2) SECONDARY OBJECTIVES To find of P/E ratios of Indian Banking Sector & Pharma sector companies To do P/E ratio analysis of some of these companies1.2) NEED FOR STUDYValuation of equities is generally not understood properly by investors. Most of the investorshave herd mentality and rely completely on TV channels, Expert Tips for their investmentrelated decisions. They enter or exit from particular stock at wrong value and incur hugelosses. To avoid such situations we need to study PE ratio, an important decision making tool. 4
  5. 5. 1.3) SCOPE OF THE STUDYThe study of PE ratio and its applications is important to understand which stocks areexpensive and which are cheaper. The study is limited to 6-6 Banking & Pharma sectorstocks.1.4) REASEARCH METHODOLOGYResearch is an art of systematic investigation. The primary purpose of research isdiscovering, interpretation and development of method.1.4.1) TYPE OF RESEARCHDescriptive research methodology is used for this study. Theoretical study followed byObservation and analysis is done on the selected stocks.1.4.2) SOURCE OF DATANo primary source of data collection is used. Only Secondary source of data is used. Traderterminal, Broker websites, Equity Research related websites, articles, books etc. used for thedata collection.1.4.3) TOOLS FOR ANALYSISPE values of stocks is used as only tool of analysis1.5) BASIS FOR SELECTION OF COMPANIESThe most sough-after Banking Sector stocks of the year 2012 (Jan-June) are used as the listhad good combination of Private sector and Public sector. Pharma Sector stock are selectedrandomly. 5
  6. 6. BACKGROUND 6
  7. 7. 2) BACKGROUND2.1) STRUCTURE OF BANKING INDUSTRY IN INDIA The Indian banking can be broadly categorized into nationalized (government owned),private banks and specialized banking institutions. The Reserve Bank of India acts ascentralized body monitoring any discrepancies and shortcoming in the system. 7
  8. 8. 2.2) LIST OF BANKS IN INDIA2.2.1) Central Bank in India Reserve Bank of India2.2.2) Nationalized Banks State Bank of India State Bank of Bikaner & Jaipur State Bank of Hyderabad State Bank of Mysore State Bank of Patiala State Bank of Travancore Allahabad Bank Andhra Bank Bank of Baroda Bank of India Bank of Maharashtra Canara Bank Central Bank of India Corporation Bank Dena Bank IDBI Bank Indian Bank Indian Overseas Bank Oriental Bank of Commerce Punjab National Bank Punjab and Sind Bank Syndicate Bank Uco Bank United Bank of India Union Bank of India Vijaya Bank 8
  9. 9. 2.2.3) Old Private Sector Banks/Societies Catholic Syrian Bank City Union Bank Dhanlaxmi Bank Federal Bank Jammu & Kashmir Bank Karnataka Bank Karur Vysya Bank Lakshmi Vilas Bank Nainital Bank South Indian Bank Tamilnad Mercantile Bank Bank of Rajasthan merged with ICICI Bank in 2010. Saraswat Bank2.2.4) New private sector banks Axis Bank HDFC Bank ICICI Bank IndusInd Bank ING Vysya Bank Kotak Mahindra Bank Yes Bank DCB Bank 9
  10. 10. 2.3) Banking Sector companies under study:About top banks in IndiaListed below are the names of the top banks in India:2.3.1) State Bank of India (SBI)Headquartered in Mumbai, State Bank of India (SBI) is the largest financial and bankingservices provider in India. It was founded in 1806. The bank offers a range of PersonalBanking, NRI Services, International Banking, Agriculture/Rural Banking, CorporateBanking and SME Banking services.2.3.2) HDFC BankHDFC Bank was founded in 1994. It is one of the biggest banks in India. Based in Mumbai,the bank offers a suite of services including accounts and deposits, private banking, creditcards, payment services and forex services.2.3.3) ICICI BankICICI Bank is the second biggest bank in India. The bank has 2014 branches and 5,219ATMs throughout India. ICICI Bank offers a host of services including personal banking,NRI banking, corporate banking, business banking and agricultural and rural banking.2.3.4) Punjab National Bank (PNB)Punjab National Bank (PNB) is the 2nd largest public sector bank in India. It was founded in1894. Products and services of the bank include personal banking, social banking, corporatebanking and business financing.2.3.5) Canara BankHeadquartered in Bangalore, Canara Bank ranks as the 5th biggest bank in India. It wasfounded in 1906. It is one of the oldest banks in India. Canara Bank offers products andservices like corporate banking, personal banking, NRI banking and priority and SME credit.2.3.6) Axis BankAxis Bank (erstwhile UTI Bank) was founded in 1994. It is one of the “big four” banks inIndia. The products and services include personal, corporate, NRI and priority banking. It isheadquartered in Mumbai. 10
  11. 11. 2.4) OTHER DATA ABOUT BANKING SECTORWe can see that except the global depression period of 2008-2009 Indian sector Banks havealways shown gradual growth.Some more important recent statistics: 11
  12. 12. 2.5) Life Science companies2.5.1) Pharmaceutical industry in IndiaThe number of purely Indian pharma companies is fairly low. Indian pharma industry ismainly operated as well as controlled by dominant foreign companies having subsidiaries inIndia due to availability of cheap labour in India at lowest cost.Most of the players in the market are small-to-medium enterprises; 250 of the largestcompanies control 70% of the Indian market. Thanks to the 1970 Patent Act, multinationalsrepresent only 35% of the market, down from 70% thirty years ago.Most pharma companies operating in India, even the multinationals, employ Indians almostexclusively from the lowest ranks to high level management. Mirroring the social structure,firms are very hierarchical. Homegrown pharmaceuticals, like many other businesses inIndia, are often a mix of public and private enterprise. Although many of these companies arepublicly owned, leadership passes from father to son and the founding family holds amajority share.In terms of the global market, India currently holds a modest 1-2% share, but it has beengrowing at approximately 10% per year. India gained its foothold on the global scene with itsinnovatively engineered generic drugs and active pharmaceutical ingredients (API), and it isnow seeking to become a major player in outsourced clinical research as well as contractmanufacturing and research.2.5.2) Top 20 Pharma Companies in ‘Life Sciences’ category in India : 1) Cipla 11) GlaxoSmithKline Pharma 2) Ranbaxy 12) Ipca Pharma 3) Dr. Reddy’s lab 13) Wockhardt 4) Lupin Ltd. 14) Torrent Pharma 5) Aurobindo Pharma 15) Sterling Bio 6) Dabur 16) Biocon 7) Sun Pharma 17) Orchid Chemicals 8) Cadilla Healthcare 18) Alembic 9) Jubiliant LifeScience 19) Aventis Pharma 10) Piramal Heathcare 20) Glenmark Pharma 12
  13. 13. 2.6) Life Science Companies under study:2.6.1) Ranbaxy Laboratories Limited : is an Indian pharmaceutical company that wasincorporated in India in 1961. The company went public in 1973 and Japanesepharmaceutical company Daiichi Sankyo gained majority control in 2008. Ranbaxy exportsits products to 125 countries with ground operations in 46 and manufacturing facilities inseven countries. In 2011, Ranbaxy Global Consumer Health Care received the Pharma OTCCompany of the year award.2.6.2) Cipla Limited : is a prominent Indian pharmaceutical company, best-known outsideits home country for manufacturing low-cost anti-AIDS drugs for HIV-positive patients indeveloping countries. It has played a similarly prominent role in expanding access to drugs tofight influenza, respiratory disease and cancer. Cipla makes drugs to treat cardiovasculardisease, arthritis, diabetes, weight control, depression and many other health conditions, andits products are distributed in virtually every country of the world.2.6.3) Lupin Ltd.: is worlds largest manufacturer of the anti-TB drugs basedin Mumbai, Maharashtra, India. The company production contains the Cardiovascular (prilsand statins), Diabetology, Asthma, Pediatrics, CNS, GI, Anti-Infectives and NSAIDs therapyand world largest manufacturer of Anti-TB and Cephalosporins segments. 2.6.4) Sun Pharmaceutical Industries: is an international pharmaceutical company basedin Mumbai,India that manufactures and sells pharmaceutical formulations and activepharmaceutical ingredients (APIs) primarily in India and the United States. The companyoffers formulations in various therapeutic areas,such as cardiology, psychiatry, neurology,diabetology & gastroenterology . It also provides APIs comprising warfarin, carbamazepine,etodolac, and clorazepate, as well as anticancers, steroids, peptides, sex hormones, andcontrolled substances.2.6.5) Wockhardt Ltd. Is a pharmaceutical and biotechnology company headquarteredin Mumbai, India. The company has manufacturing plants inIndia,UK, Ireland, France and US, and subsidiaries in US, UK, Ireland and France. It is aglobal company with more than half of its revenue coming from Europe. Itproduces formulations, biopharmaceuticals, nutrition products, vaccines and activepharmaceutical ingredients(APIs).2.6.6) Biocon Limited is a global biopharmaceutical company with products and researchservices ranging from pre-clinical to clinical development through to commercialization.Within biopharmaceuticals, the Company manufactures generic active pharmaceuticalingredients (APIs) like Statins and Immunosuppressants that are sold in the developedmarkets of the United States and Europe. It also manufactures biosimilar Insulins, which aresold in India as branded formulations and in both bulk and formulation forms. 13
  14. 14. METHODOLOGY 14
  15. 15. 3) METHODOLOGY3.1) LITERATURE REVIEW3.1.1) INVESTMENT In finance, investment is the commitment of funds by buying securities or othermonetary or paper (financial) assets in the money markets or capital markets, or in fairlyliquid real assets, such as gold or collectibles. Valuation is the method for assessing whethera potential investment is worth its price. Returns on investments will follow the risk-returnspectrum. Types of financial investments include shares, other equity investment, and bonds(including bonds denominated in foreign currencies). These financial assets are then expectedto provide income or positive future cash flows, and may increase or decrease in value givingthe investor capital gains or losses. Trades in contingent claims or derivative securities do not necessarily have futurepositive expected cash flows, and so are not considered assets, or strictly speaking, securitiesor investments. Nevertheless, since their cash flows are closely related to (or derived from)those of specific securities, they are often studied as or treated as investments. Investments are often made indirectly through intermediaries, such as banks, mutualfunds, pension funds, insurance companies, collective investment schemes, and investmentclubs. Though their legal and procedural details differ, an intermediary generally makes aninvestment using money from many individuals, each of whom receives a claim on theintermediary. Within personal finance, money used to purchase shares, put in a collectiveinvestment scheme or used to buy any asset where there is an element of capital risk isdeemed an investment. Saving within personal finance refers to money put aside, normally ona regular basis. This distinction is important, as investment risk can cause a capital loss whenan investment is realized, unlike saving(s) where the more limited risk is cash devaluing dueto inflation. 15
  16. 16. 3.1.2) ANALYSIS OF STOCKSMany investors lose their lots of hard-earned money in share market due to lack ofknowledge about the companies in which they invest. Its very important to pick properstocks to avoid huge losses in share market. Rather than completely depending on stock tipsby experts; an investor should himself do some basic research about the companies in whichhe/she wants to invest. Therefore its mandatory to have a basic knowledge about the majormethods of analysis of stocks;so as to pick up the right stocks of the right sector at rightprice.The two basic methodologies areA) Fundamental AnalysisB) Technical Analysis A) Fundamental Analysis Fundamental analysis considers financial and economic data that may influence theviability of a company. The basic of fundamental analysis lies in understanding the businessof the company properly and the industry in which it operates. The fundamentals of a firmcan be analysed quantitatively as well as qualitatively. Fundamental analysis helps to decide investors whether to buy or sell a particularstock depending upon its current market price and the intrinsic value. It is useful for investorsin long run as they can buy shares when they are undervalued and sell them when they areoverpriced depending on the market movements. B) Technical Analysis Technical analysis involves a study of past market generated data like prices andvolumes to determine the future direction of price movement. As technical analysis focuseson price and volume data it is extremely useful for traders and speculators who seek topredict short term price movements. Basic concepts of technical analysis involves study of trends, relationshipbetween volume and trend and determination of support and resistance levels. Investors can use single approach or can use combination of both depending uponhis/her risk appetite, duration of financial goals and investment period. 16
  17. 17. 3.1.3) FUNDAMENTAL ANALYSISFundamental Analysis: A method used for the evaluation of intrinsic value of a securityby analyzing financial and economical data of a company/industry using quantitative andqualitative techniques.Fundamental analysis uses E-I-A Analysis approach (Economic ----->Industry ------>Company)Economic Analysis• Growth rate of GDP• Balance of trade• Foreign reserves and exchanges rates• Government Budget and Deficit• Price level and Inflation• Interest rates• Savings and investments• Agriculture and Industrial growth parameters• Infrastructure facilities and arrangements• SentimentsIndustry Analysis• Industry life cycle Analysis• Profit potential of industriesCompany Analysis• Ratio Analysis• Valuation of firm• Non financial analysis 17
  18. 18. 3.1.4) FINANCIAL RATIOSRatio Analysis is very important quantitative method of Fundamental analysis. Financialratios can be broadly categorize as follows:Liquidity measurement ratios:Current ratioQuick ratioCash ratioProfitability indicator ratios:Return of AssetsReturn of EquityReturn on Capital EmployedDebt ratios:Debt ratioDebt-Equity ratioInterest coverage ratioOperating Performance ratios:Fixed-Asset turnoverSales/Revenue per employeeCash flow indicator ratios:Operating cash flow/ Sales ratioDividend payout ratioInvestment Valuation Ratios:Per Share dataPrice/Earning ratioPrice/Sales ratio 18
  19. 19. 3.1.5) WHAT IS P/E RATIO ? Price per Earnings = Price per share / Earnings per share The Price per Earnings ratio (PE ratio) is best known investment valuation ratio.This ratio has two very sensitive components.The numerator depends on the market expectations and perceptions about the firmsperformance. The denominator represents the earnings left for distribution to the firmsshareholder after meeting the claims of the debtors. Both components are subject to widefluctuations from time to time.In finance the PE ratio of stock is used to determine how cheap or expensive the share pricesare.The price per share (numerator) is the price of a single share of the stock.The earnings pershare (denominator) is the net income of the company for the most recent 12 month period;divided by number of shares outstanding.The PE of a stock describes the price of a share relative to the earnings of the underlyingasset The lower the PE;the less you have to pay for the stock,relative to what you can expectto earn from it. The higher the PE ratio the more over-valued the stock is.Example: Suppose if any stock is trading at Rs. 70/- and Earnings per share for the mostrecent 12 month period is Rs. 10/- Then the PE ratio = 70/10 = 73.1.6) FACTORS WHICH INFLUENCE THE PRICE/EARNINGS RATIOTangible factors: These are available in financial statements and can be quantified 1. Profitability 2. Dividend rate 3. Growth rate of past earnings and sales 4. Consistency of past earnings 5. Creditworthiness 6. Financial Strength 7. Historical PerformanceIntangible factors: These factors give clear picture of financial position of firm. Theyinfluence the tangible factors to large extent but can not be quantified. 1. Status of the firm 2. Nature of business 3. Quality of management 4. Future growth prospects of industry 5. Competitive nature of the firm 6. Expectations 19
  20. 20. 3.1.7) Components of PE Ratio • Price per share (Market value per share) • Earnings per share Market Value Market Value is the current quoted price at which investors buy or sell a share ofcommon stock or a bond at a given time. And it is also known as "market price". Market value is often different from book value because the market takes into accountfuture growth potential. Most investors who use fundamental analysis to pick stocks look at acompanys market value and then determine whether or not the market value is adequate or ifits undervalued in comparison to its book value, net assets or some other measure. Market Average A measure of the overall price level of a given market, as defined by a specified groupof stocks or other securities. A market average equals the sum of all current values of stocksin the group divided by the total number of shares in the group. Earnings per Share The portion of a companys profit allocated to each outstanding share of commonstock. EPS serves as an indicator of a companys profitability. The EPS formula does not include preferred dividends for categories outside ofcontinued operations and net income. Earnings per share for continuing operations and netincome are more complicated in that any preferred dividends are removed from net incomebefore calculating EPS. Only preferred dividends actually declared in the current year are subtracted. Theexception is when preferred shares are cumulative, in which case annual dividends arededucted regardless of whether they have been declared or not. Dividends in arrears are notrelevant when calculating EPS. 20
  21. 21. 3.1.8) Types of EPS On the basis of Shares Outstanding By definition, EPS is net income divided by the number of shares outstanding;however, both the numerator and denominator can change depending on how you define"earnings" and "shares outstanding". Because there are so many ways to define earnings, wewill first tackle shares outstanding.Shares outstanding can be classified as either primary(primary EPS) or fully diluted (diluted EPS). • Primary EPS is calculated using the number of shares that have been issued and held by investors. These are the shares that are currently in the market and can be traded. • Diluted EPS entails a complex calculation that determines how many shares would be outstanding if all exercisable warrants, options, etc. were converted into shares at a point in time, generally the end of a quarter. We prefer diluted EPS because it is a more conservative number that calculates EPS as if all possible shares were issued and outstanding. The number of diluted shares can change as share prices fluctuate On the basis of context of the type of "earnings" being used. There are five types of EPS• Reported EPS (or GAAP EPS) We define reported EPS as the number derived from generally accepted accountingprinciples (GAAP); The Company derives these earnings according to the accountingguidelines used. A companys reported earnings can be distorted by GAAP. For example, a one-timegain from the sale of machinery or a subsidiary could be considered as operating incomeunder GAAP and cause EPS to spike. Also, a company could classify a large lump of normaloperating expenses as an "unusual charge" which can boost EPS because the "unusualcharge" is excluded from calculations. Investors need to read the footnotes in order to decidewhat factors should be included in "normal" earnings and make adjustments in their owncalculations. 21
  22. 22. • Ongoing EPS This EPS is calculated based upon normalized or ongoing net income and excludesanything that is an unusual one-time event. The goal is to find the stream of earnings fromcore operations which can be used to forecast future EPS. This can mean excluding a largeone-time gain from the sale of equipment as well as an unusual expense. Attempts todetermine an EPS using this methodology is also called "pro forma" EPS.• Pro Forma EPS The words "pro forma" indicate that assumptions were used to derive whatevernumber is being discussed. Different from reported EPS, pro forma EPS generally excludessome expenses/income that were used in calculating reported earnings. For example, if acompany sold a large division, it could, in reporting historical results, exclude the expensesand revenues associated with that unit. This allows for more of an "apples-to-apples"comparison. Headline EPS The headline EPS is the EPS number that is highlighted in the companys pressrelease and picked up in the media. Sometimes it is the pro forma number, but it could also bean EPS number that has been calculated by the analyst/pundit that is discussing the company.Generally, soundbites do not provide enough information to determine which EPS number isbeing used.Cash EPS Cash EPS is operating cash flow (not EBITDA) divided by diluted shares outstanding.We think cash EPS is more important than other EPS numbers because it is a "purer" number.Cash EPS is better because operating cash flow cannot be manipulated as easily as netincome and represents real cash earned, calculated by including changes in key assetcategories such as receivables and inventories. 22
  23. 23. EPS & Extraordinary items An item included in a company’s Accounts that is not likely to occur again, such as an Acquisition or sale of assets. • EPS before extra ordinary items: EPS calculated before these items included in the account is called EPS before extra ordinary items. • EPS after extra ordinary items: EPS calculated after these items included in the account is called EPS after extra ordinary items.3.1.9) GROWTH OF EARNINGS If a company has a P/E higher than the market or industry average, this means that themarket is expecting big things over the next few months or years. A company with a high P/Eratio will eventually have to live up to the high rating by substantially increasing its earnings,or the stock price will need to drop. The P/E ratio is a much better indicator of the value of astock than the market price alone. That being said, there are limits to this form of analysis -you cant just compare the P/Es of two different companies to determine which a better valueis. Its difficult to determine whether a particular P/E is high or low without taking intoaccount two main factors: 1. Company growth rates - How fast has the company been growing in the past, andare these rates expected to increase, or at least continue, in the future? Something isnt right ifa company has only grown at 5% in the past and still has a stratospheric P/E. If projectedgrowth rates dont justify the P/E, then a stock might be overpriced. In this situation, all youhave to do is calculate the P/E using projected EPS. 2. Industry - It is only useful to compare companies if they are in the same industry.For example, utilities typically have low multiples because they are low growth, stableindustries. In contrast, the technology industry is characterized by phenomenal growth ratesand constant change. Comparing a tech company to a utility is useless. You should onlycompare high-growth companies to others in the same industry, or to the industry average. 23
  24. 24. 3.1.10) HOW TO INTERPRET P/E RATIO?Price per earnings ratio interpretation is mainly done considering the environment of thecompany in which it operates i.e. industry etc.1) Compare:P/E ratio doesn’t have any utility on standalone, isolated basis. This implies thatIt should always be used to compare two companies, countries, sectors, countries etc.It should be used along with other tools of valuation and analysis2) Criteria of ComparisonIt is very important to understand companies operating in same industry can be compared.Also comparison of P/E ratio of one company to the average P/E of company is allowed.Thus ‘High P/E’ of company means P/E of that company is higher than average P/E of thecompanies in same league.3) Thumb RuleGenerally companies in mature industries or markets have stable and moderate growth rate.Such companies have a low to moderate P/E ratio.Companies in high growth industries or market shows rapid growth.These companies do havea moderate to high P/E ratio.Depending on these important aspects of P/E ratio related rules we can interpret:A) Undefined P/EA company with no earnings has an undefined P/E ratio. The companies which have hugelosses and have some fundamental issues generally show negative P/E ratio. Even thoughmathematically we can calculate such negative P/E ratios by convention they are consideredas ‘undefined’.B) 0-10Either the company in undervalued or the earnings of the company are thought to be indecline.C) 10-25 This range can be considered a fair value of P/E. The range describes companies which areeither undervalued or are in growing phase. The earnings of the stocks are expected to growin future.D) 25+Stocks with such higher P/E may show growth potential in the companies. High P/E meansinvestors are ready to pay premium prices for buying these already overvalued stocks. Thehigh earnings expectations from such stocks can create speculative bubble sometimes.Please note, average P/E ratio of companies differ from industry to industry. 24
  25. 25. 3.1.11) Concepts related to P/E Publically traded companies often make quarterly cash payments to their own shareholders, in direct proportion to the number of shares held. This is termed as dividend. Consider the formula below: P/E = P/D * DPR Here, P/D = Price per dividend ratio & DPR= Dividend payout ratio = Dividend / EPS This is how P/E is related to Dividend We can rewrite the above formula as P/D = P/E / DPR Here, reciprocal of DPR is known as Dividend cover (DC) Therefore, P/D = P/E * DC Please note;· P/E ratio and Earning yield are reciprocals· P/D ratio and Dividend yield are reciprocals· DPR and DC are reciprocals ABSOLUTE PE and RELATIVE PE ABSOLUTE PE: Absolute PE is the price of a stock divided by the company’s earnings per share. This measure indicates how much an investor is willing to pay per Rupee of earnings. Absolute PE represents the PE of the current period RELATIVE PE: Relative P/E compares the current absolute P/E to a benchmark or a range of past P/Es over a relevant time period, such as the last 10 years. Relative P/E shows what portion or percentage of the past P/Es the current P/E has reached. The relative P/E will have a value below 100% if the current P/E is lower than the past value (whether the past high or low). If the relative P/E measure is 100% or more, this tells investors that the current P/E has reached or surpassed the past value. 25
  26. 26. 3.1.12) PROBLEMS WITH P/E RATIOThere are some pitfalls in uses of P/E ratio as followsMarket Sentiment: In bearish market when investors have low interest in equity, most ofthe stocks are oversold. The P/E ratio of some good companies may get undervalued, whichcould show very less growth prospects to investors.Accounting methods: Book-keeping and accounting of companies is done according toguidelines of Generally Accepted Accounting Principle, which may change from time to timeand country to country. Hence value of EPS can be reached in various different ways whichresults in confusion while comparing P/Es.Economic cycles: Business operates in economic cycles. During downturn EPS will be lowbut P/E will be inflated or vice versa. In growth phase the investment can be huge. In suchcase depreciation can suppress earnings which may mislead the investors.Inflation: It is important to look earnings over a time while calculating P/E ratio. Inflationmakes this difficult as historical data becomes irrelevant during inflation period. Role ofdepreciation and inventory in calculations of EPS may be underestimated during this phase.Also investors may think that earnings might be artificially distorted upwards.Interpretation mistakes: Low P/E is fair P/E value to enter in stocks as Low P/E isinterpreted as undervalued stock. This interpretation can become a big mistake sometimes aslow P/E can further decline to enter in negative or undefined P/E ratio zone. This can happenwhen some companies are undergoing gradual decline over time.Not a powerful metric in standalone: P/E ratio doesn’t give accurate idea about stock movements as there are other parameterswhich affect stock prices in market. Margins, cash generating ability, performance over time,other ratios etc. should be used along with P/E to increase its reliability for decisionsregarding long or short positions of stocks.Expectations: High P/E ratio of stocks captures eyeballs of investors. The growthexpectations about the stock value sometimes results into heavy buying of such stocks whichin turn leads to overvaluation of stocks.Negligence: Some companies with good fundamentals don’t get limelight. Their share valuemay remain undervalued for longer time as investors, institutions or brokers may neglect itdue to its low P/E value. Thus only actively tracked stocks show high volume of trading.Relation between high EPS and P/E ratio is tenuous:Strong growth in earnings doesn’t always translate into high P/E ratios.Firms with similar growth rate often don’t sell at same P/E ratioMarket determines value on long term expectations rather than short term performance. 26
  27. 27. 3.1.13) P/E ratios in India during 1990 and 2005See Table 1 given below, the price-earnings ratio for companies listed in SENSEX wentdown from 19.68 in March 1991 to 16.05 in March 2005, i.e., an average drop ofapproximately 1.5% per year. Similarly, the price earnings ratio for companies listed in BSE-100 dropped by approximately 2.4% per year.Predictions regarding the Indian Stock Markets during 2005 and 2015The following three main components are likely to result in a strong upward movement ofIndian markets:1. During April 2005 and March 2015, companies listed in SENSEX, BSE-100, and BSE-500are expected to grow at an annual average rate of 11% (in real terms) and 17% (in nominalterms).2. In March 31, 2005, the firms in SENSEX were trading at an average P/E ratio of 16.05whereas they were trading at an average price earnings ratio of 22.8 during 1991 and 2005.Analysis shows that by December 2015, these firms (that are part of SENSEX, BSE-100, andBSE-500) are likely to trade at an average P/E ratio of 22.8 also, partly because of volatilityand partly because the annual growth rates of these companies is quite high when comparedto their counterparts in the United States and other developed countries.3. Since India (and other emerging countries) are growing rapidly – as much as 7-8% more –than their counterparts in the United States, we believe that the SENSEX, BSE-100, andBSE-500 will trade at an average price/earnings ratio of 22.8 (during 2005 and 2015). 27
  28. 28. 3.1.14) APPLICATIONS OF PE ratioANALYTICAL DEVICE:PE ratio is a valuable analytical device in assisting investors in evaluating stock prices fromlong term perspectives and is particularly helpful in difficult analysis of shocking economicdays.VALUATION TOOL :Understanding PE gives the investors an idea if the stock has sufficient growth potential.Stocks with low PE can be considered good bargains as their growth potential is stillunknown to the market.If the PE is high, it warns of an over-priced stock. It means the stocksprice is much higher than its actual growth potential. So these stocks are more liable to crashdrastically.ESTIMATION OF EPS :PE ratio encapsulates the level of EPS, the quality of EPS and the future prospects of firm’sgrowth potential in EPS.DECISION MAKING TOOL:Buy-Hold-Sell related decisions regarding investments in stocks can be easily tookconsidering the PE value of the stock. Whether to take long position or to short the stocks,when to exit or when to enter stock etc. decisions can be easily taken when you know how tointerpret PE ratios properly. With the help of PE Ratio and investor can decide whether astock is cheap or expensive to purchase. It helps to minimize the risk of investors.A POWERFUL METRIC:PE ratio is simple and yet powerful metric from the perspective of retail investors. Bycomparing price and earnings per share for a company, one can analyze the marketsvaluation of a company’s future earnings potential. Another way to look at this ratio is that, itindicates the number of years required to pay back the current purchase price of the shares(ignoring the time value of money) .The PE Ratio of a specific industry can be used toevaluate the whole market of that industry. You can evaluate the PE Ratio of the stock of abusiness by comparing it with standard market PE ratio of that industry. 28
  29. 29. 3.2) DATA & OBSERVATIONS3.2.1) PE Ratios of Banking Sector StocksIn the table below, PE ratios of Banking stocks as on 13th June 2012 are tabulated. BANK NAME CMP EPS PE Value (Rs.) (Rs.) (Ratio) PUBLIC SECTOR BANKSState Bank of India 2150. 25 174.46 12.74Allahabad Bank 137.05 37.33 3.85Andhra Bank 113.40 24.03 4.82Bank of Baroda 694.10 121.42 5.92Bank of India 348.10 46.60 7.65Bank of Maharashtra 51.10 7.31 7.42Canara Bank 412.65 74.10 5.83Central Bank of India 80.45 7.24 11.24Corporation Bank 438.60 101.67 4.32Dena Bank 96.35 22.94 4.35IDBI Bank 90.45 15.89 5.87Indian Bank 174.95 40.65 4.38Indian Overseas Bank 89.45 13.18 6.71Oriental Bank of Commerce 241.45 39.13 6.24Punjab National Bank 769.45 144.00 5.65Punjab and Sind Bank 69.25 19.27 3.72Syndicate Bank 101.30 21.82 4.69 29
  30. 30. Uco Bank 78.10 16.68 4.76United Bank of India 63.80 17.52 3.88Union Bank of India 208.00 27.01 7.89Vijaya Bank 58.00 11.72 5.05 OLD PRIVATE SECTOR BANKSCity Union Bank 48.65 6.87 7.21Dhanalaxmi Bank 54.25 -13.58 - 4.09Federal Bank 421.80 45.41 9.44Jammu and Kashmir Bank 912.15 165.65 5.54Karnataka Bank 86.40 13.07 6.29Karur Vysya Bank 417.10 46.81 8.81South Indian Bank 23.60 3.54 6.70 NEW PRIVATE SECTOR BANKSAxis Bank 1013.05 102.67 10.19HDFC Bank 534.40 22.02 24.65ICICI Bank 818.85 56.08 15.14IndusInd Bank 314.40 17.16 18.74ING Vysya Bank 331.40 30.40 11.14Kotak Mahindra Bank 568.20 14.65 39.89Yes Bank 332.05 27.68 12.50DCB Bank 40.55 18.07 2.32Note: CMP = Current Market Price EPS = Earnings Per Share 30
  31. 31. 3.2.2) Determination of P/E values of ‘Banks’.In the table below, given the data of EPS and Finding the Average Market price of stock on15th June 2012, the PE Value of top 6 banks (banks under consideration) has been calculatedusing formula of PE.No. BANK NAME Day’s Day’s Average Earnings PE High Low per Ratio Market share (Rs.) (Rs.) Price (EPS) (Value) (Rs.) (Rs.)1 State Bank of India (SBI) 2189.85 2147.00 2168.42 174.46 12.422 HDFC Bank 549.70 534.95 542.32 22.02 24.623 ICICI Bank 855.55 823.15 839.35 56.08 14.964 Punjab National Bank (PNB) 795.00 772.55 758.77 144.00 5.275 Canara Bank 425.20 411.10 418.15 74.10 5.646 Axis Bank 1038.35 1010.00 1024.17 102.67 9.97 Bar Chart Representation of Above data: 25 20 15 PE Value 10 5 0 SBI HDFC ICICI PNB CANARA AXIS 31
  32. 32. 3.2.3) Determination of P/E ratio values of ‘Life Science’ companies:Day’s High-Low prices of the stocks and EPS are used to calculate PE values of below ‘LifeScience’ companies on 15th June 2012.Company Day’s High Day’s Low Average EPS PE Value (Rs.) (Rs.) (Rs.) (Rs.) (Ratio)Ranbaxy 480.70 471.10 475.9 -72.32 - 6.58Cipla 310.75 304.00 307.37 14.00 21.95Lupin 518.00 505.10 511.55 18.01 28.40Sun Pharma 596.50 583.70 590.1 18.62 31.69Wockhardt 856.20 827.45 841.82 16.81 50.07Biocon 222.00 216.70 219.35 12.78 17.16Bar chart representation of above data:60504030 PE Value2010 0-10 Ranbaxy Cipla Lupin Sun Pharma Wockhardt Biocon 32
  33. 33. 3.3) ANALYSIS and INTERPRETATIONSANALYSIS Analysis of data means studying the tabulated materials in order to determine inherentfacts or meanings. It involves breaking down, existing common factor into simpler parts andputting the parts together in new arrangements for the purpose of interpretation. This processrequire flexible and open mind. No similarities, differences, trends and outstanding factorsshould go unnoticed. Large divisions of material should be broken down into smaller unitsand rearranged in new combinations to discover new factors and relationships. Data shouldbe studied from as many angles as possible to find out new and newer facts.Interpretation Analysis and interpretation are central steps in the research process. The goal ofanalysis is to summarize the collateral data in such a way that they provide answer toquestion that triggered the research. Through interpretation the meanings and implications ofthe study become clear. Analysis is not complete without interpretation and interpretationcannot proceed with analysis. This research has two major aspects. First there is the effort toestablished continuity in social research through linking the result of one study with those ofanother. Secondly interpretation leads to the establishment explanatory concepts. In the case of P/E analysis of Banks and Life Science companies in this Study, OurAnalysis is solely based on the P/E ratios calculated using Average Share Price on 15th June2012 and EPS value of 12th March 2012. Banking Sector stock were badly hurt duringslowdown after Greece Crisis and Global economic conditions while Pharma Sectorcompanies weathered the storm successfully. Hence the ranges of PE values andInterpretation criteria are different for both the industries. We will analyse PE values and interpret the results in tabular forms. 33
  34. 34. 3.3.1) DATA ANALYSIS & INTERPRETATIONS of BANKING SECTOR STOCK: Bank Name PE Analysis Interpretation Value PE Value is SBI 12.42 FAIR Rightly Valued HDFC 24.62 HIGH Overvalued ICICI 14.96 FAIR Rightly Valued PNB 5.27 LOW Undervalued CANARA 5.64 LOW Undervalued AXIS 9.97 FAIR Rightly Valued3.3.2) DATA ANALYSIS & INTERPRETATIONS of LIFE SCIENCES SECTORSTOCKS: Pharma PE Value Analysis Interpretation Company PE Value is Name Ranbaxy -6.58 UNDEFINED Undervalued / Avoided Cipla 21.95 HIGH Overvalued Lupin 28.40 HIGH Overvalued Sun Pharma 31.69 HIGH Overvalued Wockhardt 50.07 VERY HIGH Highly Overvalued Biocon 17.16 FAIR Rightly Valued 34
  35. 35. 3.4) SUGGESTIONS:Banks:Looking at the Bankex performance over the years we can expect the Banking Sector to growrapidly. So in for long term investors there is a great opportunity in Banking Sector stocks.New Private Sector Banks are performing much better than Public Sector Banks and oldpublic sector banks which reflects in their PE ratios. Hence for Short to mid-term investorsNew private Sector banks offers a good stocks for their portfolios.It has been seen that banking sector stocks have recovered from the oversold positions andthey can be bought at every declines.From the six banks under study SBI, PNB and Canara are Public Sector Banks while HDFC,ICICI and AXIS are Private Sector Banks. Hence to avoid unnecessary risks during bearmarket later banks should be preferred.PNB and CANARA banks are undervalued at this time so they can be bought at this time.SBI bank shares are trading at fair valuations and therefore you can BUY and HOLD themfor some more time.ICICI and AXIS banks are trading at fair prices and it is the right opportunity to BUY thesestocks. You can stay invested in HDFC banks but should SELL it at downturn rally as HDFCseems to be overvalued.Considering the PE Values the best Buying Private Sector Bank in the list is AXIS Bank andBest Buying Public Sector Bank is SBI Bank.In Bearish Market most risky option to buy is HDFC while in Bearish Market most riskyBuying Option is CANARA Bank.Although in long term all six Banks seems to have BUY call. But in mid-term HDFC shouldbe sold to book profits at right time and can be bought back again at some fair PE value. Inmid-term PNB and CANARA should be shorted if there is bearish situation to avoid losses,as these two stocks can be unpredictable due to its PE ratio values and Public Sector nature.SBI seems to be right Public Sector Bank to stay invested in for mid-to-long term.These all suggestions are based on the analysis and interpretation of PE Values only. Tofurther make choices accurate one should consider other fundamental factors about thecompany, future projects, quarterly results, recent news and other important ratios. 35
  36. 36. Pharma:Pharmaceutical companies are growing rapidly due to innovative technologies and import ofhigh operating standards of global parent companies. Based on the P/E ratio analysis of thesix ‘lifestyle companies’ we can suggest:Investors have lot of growth expectations from Pharmaceutical companies and therefore areready to pay more per rupee of earnings from Pharma Stocks. So the investor must hold somePharma stocks in his portfolio; to minimize the risks of bear market fall.Whenever Market is bullish Pharma stocks are first movers and whenever market falls theymove last, i.e. don’t crash.Hence PE values for some companies can be very high.From the list studied we can easily see that Ranbaxy has negative PE Value, which shows canbe due to some management related or fundamental issues. It’s better to avoid Ranbaxy atthis stage even if prima facie it seems be highly undervalued. Ranbaxy shares can be boughtat when PE value enters in less risky range of 5-10. Although investors with high riskapetite can invest in it at this stage for long term.Wockhardt seems to be highly overvalued and it can be a speculative bubble. Avoid Buyingsuch stocks as you will end up on wrong side when the market will start falling. Investment issuch already inflated stocks doesn’t make any sense. As we must stick to the ‘Buy Low, Sellhigh’ rule to minimize our losses. On every peak there will be some profit booking by FIIsand that is when you can short sell and cover position after downward rally. Small investorsshould not indulge in short selling and therefore they should better stay away from this stockat this time.Cipla, Lupin and Sun Pharma are overvalued stocks. There is moderate risk to enter in thesestocks at this time. For this kind of situation we must select stock which is traded at very highvolume. In this case Sun Pharma is good buying option compared to other two. In case if youinvest in such overvalued stock of growing sector industry; you must actively track themarket to avoid any losses.Biocon seems to be the only company whose shares are fairly valued by market at thistime.You can Buy and hold Biocon for mid-to-long term as it have huge potential of earningsin future.Overall, after doing comparative P/E ratio analysis we can conclude that Pharma Sectorcompanies are less volatile as compared to Banking Sector stocks. We must ‘Buy Cheap andSell when Expensive’ to earn good returns from our investments 36
  38. 38. 4) CONCLUSIONS & RECOMMENDATIONS4.1) CONCLUSIONS: P/E ratios are not the magical prognostic tool some once thought they were, they can still bevaluable when used in the proper manner.The P/E multiple shows how much investors are willing to pay per rupee of earnings.A higher P/E ratio suggests that investors are expecting higher earnings growth in the futurecompared to companies with a lower P/E. However, a higher P/E may also indicateovervaluation Hence, this multiple doesnt tell us the whole story by itself.The main reason to avoid company stock with high P/E ratios is that it provides you lessopportunity to make profits and more potential for losing money. Its usually more useful to compare the P/E ratios of one company to other companies in thesame industry, to the market in general or against the companys own historical P/E to cometo a reasonable conclusion about the attractiveness of the stock.P/E multiples send false signals when we ignore risk and when we don’t properly account forshareholder value added that is generated by growth.Even if the companies in same industryhave similar PE ratio, the company which have competitive advantage shows higher growthcompared to other. In other words, the P/E multiple offers no means to discriminate amongsuch companies.Although the P/E often doesnt tell us much, it can be useful to compare the P/E of onecompany to another in the same industry, to the market in general, or to the companys ownhistorical P/E ratios.4.2) RECOMMENDATIONS:Before taking decisions about stocks do comapare the other fundamentals about the companyin the same industry. Along with PE ratio also use PEG ratio, ROE, Competetive advantagefor making final decision.On long term basis equities have a great potential of earnings. Select companies which areundervalued yet have strong financial assets, good management and policies, customer base,product lines and which doesn’t have high debt and liabilities. In case if you are intradaytrader or short term investors you can take calculated risks of depending completely on PEratios for decisions about investments in equities.Buy stocks with FAIR values of PE to avoid risk of unpredictability and volatility of sharemarket. Avoid running behind herd and buying High PE if you don’t track market at regularintervals. High PE has high expectations hence book profits at right time and exit beforedownward rally starts. Time factor is really important factor when you solely depend on PEanalysis for trading in market. 38
  39. 39. LIMITATIONS 39
  40. 40. 5) LIMITATIONSThe study on ‘Price per earnings ratio and it’s applications’ has been carried out withfollowing limitations.PE ratio doesn’t offer much to institutional investors due to it’s incapability in standalone.So the study has been more focussed on retail investors.Banking Sector stocks cover large portion of portfolio of Institutional investors (includingFIIs) and therefore they can’t afford to make decisions solely using PE ratio analysis.Website Rediff Money used as data source for calculations of PE ratio gives EPS of 12thMarch (recently updated)The ranges of PE values for Interpretations are highly subjective as they change fromIndustry to Industry. 40
  41. 41. BIBLIOGRAPHYBooks:Financial Management ……………………………………Ashwath DamodaranCapital Market ……………………………………………..NCFM moduleWebsites: Ashwamedh Financial Services Deepak Doddamani 41