What drives the P/E ratio?

Let us check the P/E Ratio for the following companies.
DMart – 111, HUL – 62, Titan – 73, Infosys – 30, Tata Steel – 5

What drives the P/E Ratio?

While it is incorrect to compare this across sectors –something should explain this diverse range of values.

There are 2 key drivers of  P/E

Stability

More stable a business, higher the valuation it gets. Assume the business grows at exactly 0%, its EPS would remain same next year, and the year after that.

Thus, if I pay Rs 200 for a stock with EPS of Rs 10, I will recover your money in 20 years.

P/E can thus be loosely interpreted as the number of years in which I will get your money back, assuming Zero growth.

Now, an investor may be confident of HUL and its business existing after 50-60 years, but may not be that confident of a Steel company, or a technology company lasting that long.

Growth

Higher the growth expectation, higher the valuation. In the above example, add growth. The EPS could be 10, 12, 15, 20 over the years.

If I get my money back faster, I may pay a premium. Firms with higher growth possibilities typically get higher valuations

Now look at CAGR in earnings from 2017 to 2022

HUL – 14%, Titan – 25%, DMart – 25%, Infosys – 9%, Tata Steel went from losses to profits (so stability becomes a key parameter)

It doesn’t mean these valuations are correct. Some of them may get de-rated over the next few years, as growth subsides.

But this partly explains how markets value the companies, and why it is not a great idea to always buy low P/E stocks. We need to understand why a certain stock is getting a lower or higher P/E

That’s it for this week. Before we end, just a quick announcement.

The next batch of the FinShiksha Analyst Program is starting in Jan 2023. This is one of the most comprehensive programs around Financial Analysis and Valuation, available in India, and aims to prepare the participant to be able to value any company like an Equity Analyst would do. More details here

Till next week. Keep learning.