[Updated: 10-Apr-2021] Why people like low PE stocks? Because low PE is an indicator of undervaluation. What is the significance of undervaluation? Such stocks have the potential to yield better returns. [List of low PE stocks is here]
But relying only on ‘low PE’ for stock picking is not advisable. Because low PE of a stock may also point at ‘bad fundamentals’. Hence it is essential to double check fundamentals of ‘low PE stocks’ before making any commitment.
So let’s dig deeper into the concept of low PE stocks.
Low PE Stocks in India with its PEG Ratio
|SL||Name||M.Cap (Rs.Cr.)||P/E||Size||PEG (3Y)||GMR Score|
|7||Elecon Engineering Co||791.57||8.23||Small||0.08||35.02|
|9||Great Eastern Shippin||4,497.91||5.49||Small||0.08||34.27|
How low PE leads to better returns (dividend yield)?
In stock investing there are two forms of returns one can expect: (a) dividend earning, and (b) price appreciation. In the above infographics, you can see how lower of PE of TCS is resulting in higher dividend yield. Read more about dividend analysis of TCS.
The business fundamentals of TCS, mainly its EPS and dividend per share has remained same between 30-Apr’19 and 22-May’19. It is only the price which has changed, resulting in lower PE of TCS, hence it is yielding better returns.
How this happened? The market price of TCS has fell from Rs.2,260 levels in 30-Apr’19 to Rs.2,090 levels in 22-May’19.
How low PE leads to better returns (price appreciation)?
A low PE stock whose business fundamentals are strong has good chances of seeing future price appreciation. How? Good fundamentals leads to faster growth of sales, EPS, net worth etc. This growth eventually reflects in stock’s market price.
Example: In the above infographics, you can see that on Mar’17 PE of TCS was 10.13. This is low compared to its average trend. This was an indication of undervaluation.
As a result, in next 12 months time, TCS’s price rose from Rs.1,216 to Rs.1,425 (growth of 17.2%). What triggered this growth? Low PE in 2017, and EPS growth between Mar’17 and Mar’18. Read more about how to evaluate stocks of fast growing companies.
[Note: EPS growth is a sign of improving business fundamentals]
The PE Formula…
In order to understand the significance of lower PE of stocks, it is important to first visualise the PE formula. There are two components of PE as described below:
- Price: It is the ‘price per share’ at which a stock is currently available for trading. If market price of a stock is low, it may hint towards undervaluation. 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. Read more about low price penny stocks.
- EPS: EPS is an acronym for ‘Earning Per Share’. EPS is made up of two stock metrics, net profit, and number of shares outstanding in the market. Which stock will have higher EPS? One which is making more net profits. A company which makes more profit each passing year, will eventually have higher EPS. A growing EPS is an excellent indicator of strong business fundamental. For a given market price, the higher will be the EPS, lower will be the PE. Read more about high EPS stocks.
What PE number can be called as ‘low’?
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: Read more about investment vs speculation as described in 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. Read more about intrinsic value calculation based on Ben Graham’s formula.
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’.
What PE number can be called as ‘low’ – Today?
These days, experts no longer sees “high PE” as a bad thing. Why Because high PE could be an indicator of reliable future growth. How? Because high PE could be an indicator of ‘high demand’ for the stock. Read more about most profitable stocks.
Let’s understand it with an example of Bajaj Finance:
- Current Price: Rs.3,424.
- EPS-TTM: Rs.69.12.
- PE: 49.55 (3,424/69.12).
If we use the Benjamin Graham’s rule of PE15, Bajaj Finance is inordinately expensive. So it means, expert investors must be selling this stock, right? Not so. In last six month, Bajaj Finance stock’s has remained bullish (even at PE49 levels).
What is the reason for this optimism? Why investors are still buying this stock at PE49 levels? The reason is hidden in the business fundamentals (growth) of Bajaj Finance.
Hence, to understand if a PE is low or not, we must see it in conjunction with its potential future growth rate.
Looking at these stellar growth numbers (except for EPS which is a cause of concern), we can understand why investors continue to buy this stock even at PE49 multiples.
How to see PE with its growth rate?
Stocks which has potential of fast future growth, sell even at high PE. Why? Because modern investors are ready to pay a premium price for growth stocks. Hence such stocks sell, even at high PE multiples.
The point is, even at high PE multiple, ‘potential higher future growth rates’ makes a stock undervalued.
How to comprehend the ‘PE number’ and ‘growth rate number’ to understand if the stock is undervalued or not? This can be done using another ratio called PEG ratio. Read more about what is PEG Ratio.
A stock whose estimated PEG is less than one (< 1) can be said to be undervalued. No matter how high is the P/E ratio, if its PEG is less than one, the stock can be said to be low priced. Read more about PEG of Indian stocks.
Example of PEG Estimation
Business Fundamentals (past growth rates) of Piramal Enterprises is as below:
|Piramal Ent.||1 Year||3 Year||5 Year|
Looking at its past numbers, I will like to assume that Piramal Enterprises might grow at rate of 40% p.a. in next one year. Presently the PE ratio of Piramal’s stock is trading at 29.21. What will be its PEG?
PEG = 29.21 / 40 = 0.73
Alternative tip to identify if a PE is low or 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): Compare the stock’s PE with the PE of Index (like Sensex or Nifty). Example: As on today, Nifty’s PE ratio is 28.91. Let’s compare P/E ratio of TCS and RIL with Nifty PE and try to draw an impression about their price valuation. Check list of Nifty and Sensex stocks with its weightage.
|RIL||Oil & Gas||1,351||21.64||28.91||Looks Undervalued|
- Method 2 (Compare it with its peers): Compare the stock’s PE with the PE of their peers (Companies operating in same 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. Read more about PE Ratio for beginners.
Compare to its competitors, TCS looks overvalued.
Compare to its competitors, RIL looks very overvalued.
- Method 3 (Compare it with its own historical PE): Compare stock’s current PE with its “historical PE”. What is a historical PE of stock? It is not readily available on internet. It needs to self-calculated. Better will be to plot a chart and see if the current PE is following its trend. Example: PE trend of TCS is shown below. Based on the PE trend, it looks like TCS is better prices in May’19.
I use my stock analysis worksheet to do a detailed fundamental analysis of my stocks.
One 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.
- 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.