The stock market has made a deep plummet, today and once again the issue of overvalued companies has come to the fore.
Today there are companies which have a PE of 35 to 45. Unless some bonanaza growth is expected of these companies, the ratio simply means that for an investor to get a return on his investment, he has to wait till the 2040s!
Sounds ridiculous? Let us discuss this more.
Let us look at what PE ratio is, for an unintiated reader.
Let us take a company A.
Let us assume that it has only 100 shares. So, each one share holder, owns 1% of the company.
Now let us assume that this company makes a profit of Rs. 10,000 in a financial year.
Therefore, the share of profit for each share is Rs. 10,000 divided by 100 i.e. Rs. 100.
This is called the Earning Per Share or EPS of the share.
Now let us assume that this share is being traded in the secondary market or the stock market for a price of Rs. 700.
In that case, the PE or Price per Earning ratio of the share will be Rs. 700 divided by Rs. 100 (or the share price divided by the EPS) i.e. 7. So, if the earning of this company stays stable at Rs. 10,000 per annum, it will take a share purchaser or investor, a period of 7 years to get his money back. By the 8th year, he will start getting a return on his investment.
Now that we have put the EPS and PE definitions behind us, let us look at the current market scenario and do it with real examples.
ICICI Bank has an EPS of 32.88 Rupees in the FY ending 2007. It is trading at Rs. 720. So, the PE of ICICI bank is Rs. 720 / Rs. 32.88 or the PE is 21.89.
Now let us take another company in the same (banking) sector: Allahabad Bank.
Allahabad Bank has an EPS of Rs. 21.31 whereas its share price is Rs. 68. So, the PE of Allahabad Bank is Rs. 68 / Rs. 21.31 or the PE of Allahabad Bank is 3.19.
These simple calculations tell us that for every Rupee that ICICI Bank and Allahabad Bank earn, their price is approximately 21 and 3 times, respectively!!!
Such a big difference! Does this give you an idea of what hype can do to a share or a market?
The reason why ICICI bank trades at 21-22 times its profit in comparsion to Allahabad bank is the perception that ICICI bank is better managed than Allahabad Bank, the implication being that the latter being a public sector bank will not be as efficiently run. This argument is probably true albeit to a certain extent. For example, ICICI bank has inter branch networking and ATMs and swank offices and probably an upwordly mobile clientele. However, any business is measured by its bottomline.
The presumption that ICICI Bank, by virtue of its technology, is worth 7 times that of Allahabad bank, for every Rupee made as profit, is at best a very speculative idea. And in the current market scenario, very risky indeed.
Let us look at it from another angle. If I buy an Allahabad Bank share, my share of the company is – let us presume for a moment – not so well managed that I only earn Rs. 21.31 paise.
On the other hand, if you purchase an ICICI Bank share, your share of the company is so well managed that you make 32.88 Rupees. Common sense would say that your share of the company is better managed than mine, by a factor of about 50%. Right? Then how on earth does your share cost you more than ten times than mine? It does, because your share is better known than mine or is perceieved to be that of a good company.
At the end of the day, if I buy 150 shares of Allahabad bank - which will cost me about Rs. 15,300
and
on the other hand you buy 100 shares of ICICI bank – which will cost you Rs. 72,000
then your and my share of earning will be the same.
In other words, an investment of Rs. 15,300 in Allahabad Bank is the same as investment of Rs. 72,000 in ICICI Bank.
This simple calculation can give us an insight into how and which shares fall the most, during bearish trends in the market. I do concede that if a company like ICICI bank is managed well it will probably show better growth than another company in the same sector. But, these assumptions of better growth have to be within the realms of practical and reasonable possiblities.
When we speculate as a people or a market, we end up making either panicky or euphoric decisions. The result is that we end up buying stock even when the PE is skyrocketing. On the other hand we continue to ignore companies which have sound financials and thereby give up on opportunities to make money on them.
Even for a trader, if he buys ICICI Bank, for him to get a 10% return, the share will have to reach Rs. 792. While, using the same example of Allahabad Bank, if the stock goes to Rs. 75, he will make the same profit and with much lesser risk.
Talking about risk, let us look at the book values of each companies.
The book value of an ICICI Bank share is Rs. 270.35. (the share price is Rs. 720)
The book value of an Allahabad Bank share is Rs. 97.8 (the share price is Rs. 68 )
Conventional economics tell you that if you are buying a share below its book value, then you are less likely to lose money than if you are buying something above its book value – which in effect is paying a premium to the value.
This is not just theory. The share price of Allahabad Bank did go to Rs. 148 in the last 6 months. And the above calculations tell me that it can simply reach there, again, without much ado.
I hope this article has been of some use to the readers. I am sure if more and more people look at fundamentals of a company more than hype, lesser people will get hurt and they can smoothen the graph of their capital market invesment returns.
