The Indian market has produced many multibaggers in the last one year and one such theme which catches attention are stocks which are trading at three-digit PE and low earnings per share (EPS).
Before we go further, let us understand the relation between the PE, EPS and market price. Price earning multiple or earnings multiple is calculated by dividing market price by earnings per share (EPS).
Many small and midcap stocks have more than doubled investors’ wealth in the last one year without much improvement in the earnings, which is depicted by low earnings per share and high PE multiple.
In other words, if earnings fail to catch up in near future then companies with high PE multiple and low earnings per share could come under pressure.
Companies, which are trading with three digit PE multiples include names like Medicamen Biotec which rose 444 percent, followed by Generic Engineer which rallied 271 percent and International Combustion rose 205 percent in the last one year.
High PE may not be the only reason why a stock could witness correction. But, to safeguard from any adverse volatility, investors should first study the reason of high PE and if required try and avoid exposure to small and midcap stocks which have high PE and low EPS.
“Investors should investigate the reason for such high PEs. In most cases, such high PE is caused due to low base effect. For example, due to some reason, the EPS of a sound company drops to Rs 0.1 per share from Rs 10 per share in the previous fiscal,” Sanjeev Zarbade, Vice President, PCG Research at Kotak Securities told Moneycontrol.
“Yet, it does not mean that the value of the company should also decline commensurately. Investors have to look beyond this low EPS and make a judgment regarding the future profitability of the company,” he said.
Zarbade further added that such high PEs may also be due the expectation of a potential turning around in profits. In such cases, investors are forecasting a dramatic jump in future profits and hence such PEs may be justified.
It is prudent for investors to understand that taking investment decisions just based one parameter i.e. PE multiple might not be the right strategy.
Investors also take into account the book value, sales, replacement value of assets, brands into consideration. Hence, while on the face of it, a PE valuation of 100x is not sustainable, it is possible that investors are valuing the company on other parameters, suggest experts.
“A higher P/E may indicate that an investor is willing to pay a premium for that particular stock over actual earning based on identified factors prevailing in the market,” Dinesh Rohira, Founder & CEO, 5nance.com told Moneycontrol.
“It can also be interpreted as a speculation which doesn’t support a fundamental buying sentiment but prices moving up based on the speculations and triggered events,” he said.
Stocks with high EPS:
Most of the bluechip names have high EPS and a double digit PE ratio has given good returns in the last one year. A steady rise in EPS is a positive factor for a stock. A company’s PE should be compared with its respective peer group to make out if the stock is overvalued or undervalued.
Companies which have more than doubled investors’ wealth in the last one year with high EPS include names like MRF, Rasoi, Vardhman, Polson, and Borosil Glass. Maruti Suzuki gave over 70 percent return so far in the year currently has an EPS of Rs 248.
Investors should understand that company’s earnings and growth in earnings are the main drivers of the stock price. However, there are other things which impact the price.
“Other factors which impact the price of the stock include factors like change in product mix, change in margin profile, estimated growth, market positioning in terms of market share, new product launches & its impact on future earnings also have impact on valuations,” Arpit Jain, AVP at Arihant Capital Markets Limited told Moneycontrol.
EPS is also one of the prime parameters to examine a stock valuation. Any investment into stock should be supported by fundamental factors which come after carrying out proper analysis and timely evaluation, suggest experts.
“An ESP less than 1 indicates a poor revenue generation or inefficiency of the business to limit the operating cost which resulted in the outflow,” said Rohira.
“It also indicates an expected capex expenditure through borrowed funds which translate into high-interest outflow or through equity which lowers the earning per share,” he said.[Source:-moneycontrol]