People like “low PE stocks”. Why? Because low PE is an indicator of a good stock. What I mean by “good stock”?
In stock investing terms, good stock means, the stock is worth investing in. How we can say that?
To answer this, we will have to understand what it means by a good stock…
A good stock has few basic traits attached to it:
- High Quality: It represents a good underlying company.
- Low Valuation: Low cost of purchase for the investor.
Low PE of a stock could be an indication of “low valuation” and “high quality”. We will se how….
When a high quality stock is purchased at low price valuation, it ensures high returns. How?
For a stock investor what it means by high returns?
- Fast capital appreciation, and/or
- High dividend yield.
Which stock parameters ensures high dividend yield and fast capital appreciation?
- Low Price.
- High net profit (PAT) and its growth over time.
These two stock parameters in combination can ensure high returns.
So how this discussion of “high returns” explains the utility of “low PE stock”?
If we will look at the PE formula, PE is made up of two elements:
- Price and
- Profit (PAT).
This is what makes PE ratio a utility tool in judging future returns of stocks.
Let’s visualise further, what is PE ratio, and how it takes care of valuation, quality and future returns of stocks.
To visualise, allow me to present you the PE formula.
The PE Formula…
What is price in the above formula? The “price per share” at which a stock is currently available for buying.
If market price of a stock is low, it may lead to lower valuation.
So, in our pursuit for higher returns, we must always be in look out for low price stocks.
How to estimate if a stock’s price is low or not? Look for low PE ratio.
What is EPS in the above formula? EPS is an acronym for “Earning Per Share”.
As the name indicates, Earning per share (EPS) is a component of earnings (profit) and number of shares outstanding in the market.
How EPS is important? EPS is only the other name for companies net profit. Hence, the higher is the EPS, the better. How?
Which stock will have higher EPS? One which is making more net profit – high EPS.
A high EPS stock (which also grows with time), is an excellent indicator of high quality (strong business fundamental).
Furthermore, if the EPS of a stock is high (relative to its price) it will lead to low PE ratio, means better valuation.
Low PE means what?
There can be two conditions under which PE of a stock can be low:
- Market price is low.
- EPS is high.
But this must also be remembered that, low PE ratio does not guarantee that a stock is of high quality. We will discuss more about this in later part of this article.
At the moment lets ask a logical question related to low PE ratio.
What should be the value of PE so that it can be called as “low“? 15.
Benjamin Graham wrote this in his book, The Intelligent Investor:
Current price should not be more than 15 times the average earnings of the past three years.
According to Benjamin Graham, the lower is the PE the better.
He even proposed in his book a range of value for the PE ratio. According to him the maximum a stock’s PE ratio should go is between 10-15.
But it must also be remembered that Benjamin Graham’s book, The Intelligent Investor, was published way back in 1949.
In those times, there were less participation from “retail investors” into the stock market. Today, lot more people are investing in the stock market. So what? More participation means, more demand for stocks.
Hence, experts think that the PE limit of 10-15 is no longer valid.
In todays times there must be a different yard-stick for the quantification of “low PE stocks”.
Understanding of “Low PE” in modern times…
Today, expert investors no longer sees “high PE” ratio as a bad thing. Why?
Because high PE could be an indicator of reliable future growth. How?
Let’s understand it with an example of Cummins India.
- Current Price: Rs.795.
- EPS-TTM: Rs.26.26.
- PE: 30.27 (795/26.26).
If we use the Benjamin Graham’s rule of PE15, Cummins India is inordinately expensive.
So it means, expert investors must be selling the stocks of Cummins India at the moment, right? Not so.
In last one month, when Sensex has been getting weaker, Cummins stock’s remained strong (even at PE30 levels).
What is the reason for this optimism? Why investors are still buying stocks of Cummins India even at PE30 levels?
The reason is hidden in the business fundamentals (quality – growth) of Cummins India.
Generally, in modern time, stocks which has potential of fast future growth, sell even at high PE ratios.
Modern investors are ready to pay a premium price for growth stocks. Hence such stocks sell, even at high PE multiples.
Let’s take example of Cummins India. If you see its last 5 years growth rates, they are not as great, but the pattern is at least consistent.
For investors, it is easier to predict future growth for stocks like Cummins India, as compared to other lower quality stocks.
Hence investors are ready to buy stocks like Cummins even at PE30 levels.
What does it mean? It means, in todays times the definition of “low PE stocks” has changed.
PE of stocks must also be seen in conjunction with its potential future growth rates.
How to see PE with its growth rate?
These days, PE ratio alone is not enough. It must be seen with its future growth potential. How?
This can be done using another ratio called PEG ratio. What is PEG Ratio?
Frankly speaking, just by looking at PE ratio of stock, says too less about the stock valuation.
So what is the alternative? Do a more detailed analysis.
Embedding in the PE ratio, the EPS growth rate, can give a better visualisation of the stock’s true valuation. How to do it? PEG ratio does it for us.
Lets take an example:
There are two Stocks ABC and XYZ. Metric of these two stocks are as below:
- Market Price (ABC) : Rs.150
- EPS (ABC) : Rs.5
- PE (ABC) : 30
- Market Price (XYZ) : Rs.75
- EPS (XYZ) : Rs.2.5
- PE (XYZ) : 30
Which stock is better valued?
As PE ratio of both ABC and XYZ is identical (at 30), it is like impossible to judge which is better priced.
So what to do now?
We can analyze ABC and XYZ based on their growth potential.
One of the important parameter that tells us best about the future growth prospects of a stock, is its historic EPS growth rate.
Peter Lynch says, a fast growing stock can afford a higher PE ratio and still remain undervalued.
Suppose the EPS growth rate of ABC is 3% per annum, and that of XYZ is 5% per annum.
Dividing PE with EPS growth rate will give us PEG ratio.
Let’s calculate the PEG ratio of ABC and XYZ.
- PE (ABC) : 30
- EPSG (ABC) : 3
- PEG (ABC) : 10 (30/3)
- PE (XYZ) : 30
- EPSG (XYZ) : 5
- PEG (XYZ) : 6 (30/5)
Which stock is better priced?
As a rule of thumb, a stock which has a PEG of below one (1) is said to be undervalued.
Otherwise, we can also see the PEG ratio like this:
“In comparison between two stocks, the lower PEG stock is better valued”.
In our example, as PEG of XYZ is lower (6) than PEG of ABC (10). Hence XYZ is better valued than ABC.
How to summarise the utility of PEG ratio?
Suppose we have a stock whose PE ratio is high (say PE30). How to know if this stock is rightly valued or not?
Calculate its PEG ratio. If the calculated PEG is less than 1, it means the stock is undervalued.
In such cases we can say that, though the absolute PE of the stock is high, but as its PEG is low, it can still be treated as a “low PE stock”.
Limitations of Low PE Stocks…
Stocks whose PE is low, need not always be undervalued. The low PE may be due to “bad business fundamentals“.
Hence, it is advisable to be “sceptical” when you see a low PE stock in first place.
Once the business fundamentals are verified and found ok, “low PE” of the stock begins to make more sense.
“A quality stock, whose PE is low“, is actually what we should be looking at, right? But another bit of “scepticism” here…
Why the PE of a quality stock will be low? Yes, it is possible for a stock to trade at low PE multiples even when its business fundamentals are strong (high quality stock). Why it will be so?
This is what makes the stock market so unique and interesting for enterprising investors.
What enterprising investors does is, they are always in look for bargain stocks. What are bargain stocks? Quality stocks trading at low PE ratios.
But the challenge is, at given point in time, there will not be many low PE stocks whose quality is high.
Hence what enterprising investors do it prepare a list of potential “high quality, low PE stocks”.
What means by high quality? Those stocks whose business fundamentals are good.
What means by low PE? Those stocks whose PE and PEG both are low.
Once such a list is readily available, the investors must do a deeper analysis of these low PE stocks.
I personally use my stock analysis worksheet to do a detailed fundamentals analysis of my stocks.
Generally people skip the step of detailed stock analysis. But this is where investing in low PE stocks becomes risky.
Low PE of a stock may also be due to its loss-making underlying business.
Would like to buy stock of a loss making business simply because its PE is low? Never.
This is what is the biggest limitation of low PE stocks. Majority of low PE stocks are of bad quality. How to avoid them? Two ways:
- Estimate its PEG ratio.
- Do a detailed fundamental analysis.
Do not want to go into so much details? No problem, a quick compromise is possible. Let me share it with you…
A Quick tip to identify if a PE is low of high…
How to quickly know if a stock’s PE is low or not? There are three ways of doing it:
- Method 1: Compare it with Index.
- Method 2: Compare it with its peers.
- Method 3: Compare it with its own historical PE.
Compare the stock’s PE with the PE of Index (like Sensex or Nifty).
Example: As on today, Nifty’s PE ratio is 22.51.
Let’s compare P/E ratio of TCS and RIL with Nifty PE and try to draw an impression about their price valuation (see “Note” below)
|RIL||Oil & Gas||1,093||18.23||22.51||Looks Undervalued|
As PE of TCS is higher than that of Sensex, it looks overvalued. Whereas PE of RIL is lower than that of Sensex, hence its looks undervalued.
Compare the stock’s PE with the PE of their peers (Companies operating in same sector.)
- TCS operates in IT sector, and
- RIL operates in Oil & Gas Sector.
Let’s compare P/E ratio of TCS and RIL with the companies of their sectors and try to draw an impression about their price valuation.
As PE of TCS is higher than that of its near competition, it looks overvalued.
Though PE of RIL is less than that of Sensex, but when it’s compared with its near competitions, it looks overvalued.
Compares stocks PE with Sensex, and its peers is a way to make a quick impression about the stock’s PE ratio being low or high.
But this should not be the final judgement. A detailed fundamental analysis of the stock should be done as a final check.
Compare stock’s current PE with its “historical PE”. What is a historical PE of stocks? It is not readily available on internet. It needs to self-calculated.
How to do it? Follow the below steps:
- Step 1: Note down last 5 years price history of the stock.
- Step 2: Note down last 5 years EPS history of the stock.
- Step 3: Calculate last 5 years historical PE of the stock.
These 3 steps will take time to execute. But it is worth an effort. How? Let’s do it for TCS and try to derive a conclusion.
I have plotted the historical PE of Sensex of last 20 quarters (5 years). Idea of plotting this curve is to understand the trend of PE for TCS.
Once we can visualise the trend, we will try to guess, if TCS is following its trend or, it has deviated.
The trend of TCS is very evident. Starting from Dec’13 quarter till Mar’18, the PE of TCS has gradually been falling.
- Dec’13: PE 12.55.
- Mar’18: PE 10.87
Between this period (Dec’13 and Mar’18), average PE of TCS was 11.31.
But since last 2 quarters (Jun’18 and Sep’18), the PE of TCS has seen a massive jump.
- Mar’18: PE 10.87
- Jun’18: PE 15.97
- Sep’18: PE 20.70
So looking at these values and the chart, TCS has certainly deviated its trend towards overvaluation.
The same three (3) methods can be used to judge, if a stock’s PE can be treated as low or high.
We can use PE ratio as a tool to value good stocks.
One can calculate Price Earning Ratio (PE) easily by dividing market price of a share with its EPS.
Once we have the PE ratio of a stock, we can use it in variety of ways to draw a final conclusion.
Idea should be to correctly interpret “if we are dealing with a quality stock whose PE is low“.
The market price of a stock will tell only about how much a stock is valued by the market. It is just a speculative indicator of valuation.
EPS tells us how much profit the company has generated per share.
A combination of market price of a stock, and its EPS gives us PE ratio.
Generally market always overrates good stocks. One can use PE ratio to roughly gauge if the stock is overvalued or undervalued.
One of the effective ways to identify low PE stocks are these:
- Check if PEG is close to 1.
- Compare its PE with that of Sensex’s PE.
- Compare its PE with that of its peers PE.
- Compare its PE with its historical trend.
You can also find here a list of few stocks which are trading at low PE and Low PEG levels.
Low PE Stocks in India with its PEG Ratio 2019
(Updated for 27-February’2019)
|SL||Company||Price||M.Cap (Rs.Cr.)||P/E||PEG (1Y)||PEG (3Y)||PEG (5Y)|
|1||Tata Steel Ltd.||504||61,308||3.39||0.01||0.05||0.11|
|3||JSW Steel Ltd.||285||69,749||7.65||0.10||0.15||0.17|
|5||Tata Power Co.||67||18,284||5.17||0.03||0.04||0.05|
|8||Tata Chemicals Ltd.||557||14,273||7.45||0.05||0.12||0.17|
|10||Graphite India Ltd.||413||8,206||2.9||0.00||0.02||0.06|
|12||Yes Bank Ltd.||232||54,352||12.33||0.48||0.51||0.60|
|13||Power Grid Corp||183||95,974||11.6||1.16||0.66||1.06|
|14||Ashok Leyland Ltd.||84||25,099||13.37||0.55||0.20||0.50|
|15||LIC Housing Finance||466||23,593||10.36||2.81||0.80||0.74|
|17||Natco Pharma Ltd.||576||10,554||12.82||0.36||0.19||0.24|
|18||Rajesh Exports Ltd.||569||16,874||12.06||6.93||0.50||0.53|
|19||Indiabulls Real Estate||71||3,254||1.59||0.00||0.02||0.03|
|20||Bajaj Holdings & Invest||3,136||35,119||11.48||0.40||0.71||1.01|
|22||Gujarat Narmada Valley||260||4,087||4.18||0.08||0.08||0.18|
|23||Torrent Power Ltd.||241||11,847||10.85||0.09||0.29||0.57|
|24||ICICI Securities Ltd.||202||6,507||12.33||0.04||0.16||0.14|
|25||Oil India Ltd.||174||19,957||5.45||0.03||0.29||1.40|
- Price: Current Price (Rs.).
- P/E: Price Earning Ratio.
- MCap: Market Capitalisation (Rs.Cr.).
- PEG3: PE to EPS Growth Ratio (3 years).
- PEG5: PE to EPS Growth Ratio (5 years).
* P.Note: P/E Analysis of companies has been done without evaluating companies business fundamentals.