This is a question in every investor’s mind. Why do some companies consistently trade at a high P/E multiple even though many companies are available at a low P/E multiple? But before we understand these differences, the definition of P/E ratio needs to be clarified.
P/E ratio in stock market terminology refers to Price to Earnings ratio. It is an important parameter which most investors use to understand the valuation of a company i.e. whether the company is available at a premium or a discount. A high P/E ratio means that the company is expensive and a low P/E ratio means that the company is inexpensive, valuations wise.
Suppose a company generated a total annual earnings of Rs. 10,000 in an year and the market capitalization of the company is Rs. 10,00,000, then the P/E ratio of the company is –
P/E Ratio = 10,00,000/10,000 = 100
The P/E ratio can also be calculated by finding the ratio of share price (market cap / total number of shares) and the earnings per share (total annual earnings / total number of shares). This will give the same result as the one previously calculated using market capitalization & total annual earnings.
So, P/E ratio refers to the multiple which an investor is willing to pay for the earnings which are generated by a company. In the previously mentioned example, the P/E ratio of the stock is 100. It means that an investor who buys the shares of that company is willing to pay 100 times the total annual earnings of the company to become the company’s shareholder. If the earnings of the company stay the same, then it will take the company 100 years to produce enough earnings to match the price of the company. Generally a P/E ratio of 100 is considered extremely high for a company and it means that the company is available at a huge premium. Most investors consider a P/E ratio under 15 to be undervalued and a P/E ratio of over 35 to be overvalued. But this causes a lot of confusion amongst investors and traders who cannot understand why some companies consistently trade at a very high P/E multiple! Here are some of the companies with high P/E ratio in India at the time of writing.
| Name of the company | Stock price | P/E Ratio |
| Avenue Supermart (DMART) | Rs. 4749 | 224 |
| IRCTC | Rs. 851 | 160 |
| Dixon Technologies | Rs. 5585 | 177 |
| LTTS | Rs. 5419 | 69.2 |
| Nestle India | Rs. 19203 | 82.8 |
| Hindustan Unilever | Rs. 2321 | 64.5 |
| VIP Industries | Rs. 580 | 798 |
| Bharti Airtel | Rs. 685 | 141 |
Most of these stocks have been performing well over the past few years and are still trading at exorbitantly high P/E ratio. But why does a stock trade at such high P/E multiples? Here are the reason why a stock can trade at high P/E multiples.
1. Growth of the company
High growing companies are almost always available at a high P/E multiple. This is fairly straightforward to understand. If a company is able to generate high revenue and profit growth, then it will attract more investors which will send the price of the company skyrocketing. So investors are willing to pay a premium to get access to the high growth of the company.
If a company produces an annual revenue growth of 35%, then even if the company is trading at a multiple of 100, it’s P/E ratio will come down to 74 after one year and to 55 after the second year assuming the price of the company stays the same. Investors are willing to pay a higher multiple because of the high growth which the company generates. However one thing to note is that if the growth is slowed down due to any reason, then the stock price can fall relentlessly because the promised growth was not delivered!
2. Company Brand
Sometimes even if the company is not growing at a very high rate, the brand value of the company (also called as company pedigree or MOAT of the company) is enough for investors to accept higher multiples for the company. This makes a lot of sense because there are only a handful of companies in every sector which have survived the competition and have stood the test of time. These companies are the market leaders who are highly reliable in terms of their business acumen.
It is the brand of the company which makes people buy an iPhone over other mobile phones even though the iPhone is much more expensive. A similar thing happens in investing where a lot of investors are interested in buying say Asian Paints or Hindustan Unilever over a smaller unknown company which leads to higher multiples for such companies with good brands.
3. Safety of the business model
Every investor looks for safety when their hard earned money is on the line. There is a reason why banks don’t get very high P/E multiples because they are in a lending business which has uncertainties in terms of default, asset quality, interest rate, etc. On the other hand, a business such as the FMCG sector which contains the giant Hindustan Unilever is a very safe business to invest in. HUL produces food products and beauty products which people will need until the end of time. So there is an inherent safety when it comes to the business model of Hindustan Unilever when compared to other businesses.
Another type of business model which is considered very safe are monopoly businesses such as IRCTC. There is absolutely no competitor to the company because nobody else is allowed to compete! This means that as long as the railways sector grows, IRCTC will keep on producing great profits without really worrying about any potential competitor. Such safety in the business is enough for investors to buy such companies at a higher P/E multiple.
4. Temporary reduction in earnings
P/E ratio is composed of two parameters – Price and Earnings. Sometimes there is a temporary dip in the earnings of the company which could occur due to seasonality, external factors, company focusing on a new market, etc. One great example of this dip in earnings was the 2020 Coronavirus pandemic which caused the revenue and earnings of most companies to take a major hit for a few quarters. Every single company looked extremely overvalued because as the earnings temporarily went down, the P/E ratio rose up. Such a dip in the earnings can cause some companies to temporarily trade at a very high valuation.
5. News
This brings us into the speculator territory. Sometimes some corporate announcements, acquisitions, demergers, etc. are enough to cause the stock price to skyrocket and trade at a very high P/E multiple because there are many people who are expecting that the company will perform extremely well in the future. So, such speculators try to grab the company quickly before other investors can get their hands on it. This can cause a company to trade on extremely high valuations. Sometimes even the news of an acquisition is enough to cause a bankrupt company to trade at high valuations because of the expectations that things will improve after the acquisition.
6. Overvalued
Sometimes there are no other reasons except for the fact that the company is overvalued. This can be caused by multiple reasons, so it is difficult to pinpoint any specific reason. Maybe there is a euphoria about the company which causes a price bubble. Or maybe there is a group of big funds who are manipulating the stock price to trap retail investors. Or can it even be a clever promoter who is able to list the company at a very high valuation and gain the trust of the people? There are countless possibilities because of which a stock can be overvalued. Which is why the famous economist John Maynard Keynes has said “The markets can be irrational longer than you can remain solvent”
P/E ratio is not the only factor to decide which stocks to buy! To learn more about choosing stocks, visit this article.
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DISCLAIMER : I am not a financial advisor. I am not for or against any company which I have mentioned in this article. All the information provided here is for education purposes. Please consult a financial advisor before investing.
Contact me at investmentabshuru@gmail.com
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Very informative 👍
Thanks Renish!!
👍