This is a question in every investor’s mind. Some companies always seem to be trading at a very low P/E ratio compared to other sectors/stocks. In an efficient stock market, there should not be a very high variation of P/E ratio amongst different companies but for some reason some companies trade at a very low P/E ratio. Let’s understand the reasons behind the low P/E multiple of some companies. 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. 10,00,00 then the P/E ratio of the company is –
P/E Ratio = 10,00,00/10,000 = 10
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 10. It means that an investor who buys the shares of that company is willing to pay 10 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 10 years to produce enough earnings to match the price of the company. Generally a P/E ratio of 10 is considered fairly low for a company and it means that the company is available at a big discount. Let’s understand the reasons why some stocks trade at a low P/E multiple.
1. Growth of the company/sector
Growth is the most important factor which determines the P/E multiple which seasoned investors are willing to give to a company. Imagine a company which trades at a P/E ratio of 100. This is generally considered to be a very high P/E ratio however, if this company doubles it’s profit every quarter, then this P/E multiple is actually very low! If the price of the stock doesn’t increase at all for 1 year, then the P/E ratio of the company will change from 100 to 6.25 (P/E ratio will get halved every quarter due to the rising earnings). The earnings and growth potential for a company is generally factored in by smart investors which is why we have many companies trading at high P/E multiple. To learn more, visit this article – Why do some companies trade at a high P/E multiple?
On the other hand, if a company is not growing at a good pace, then the investors are not willing to give a high P/E multiple to such a company.
2. Small companies receive low P/E multiple
Smaller companies which are relatively unknown to the public almost always receive a lower P/E multiple compared to their counterpart. Imagine that you as an investor are getting an opportunity to buy one of two companies – TCS or a smaller unknown IT company. If both of these companies are available to you for similar valuations, you would most likely choose to invest in a company such as TCS because it is a huge brand with a very stable business model. Bigger companies also tend to be a lot more transparent compared to their smaller counterparts.
It is completely possible that the smaller company might be growing faster than the larger company but many investors like to invest only in known brands due to the trust factor involved. This causes many smaller companies to trade at low P/E multiples.
3. Investor safety in the sector
Smart investors always look at the safety of their capital when investing in any company. It doesn’t matter if a company is growing at a massive rate, if the future of the business is shaky or if it is a seasonal business, many smart investors will stay away from such companies. You would have seen companies which are in the FMCG sector trading at P/E multiples of over 60 which is considered fairly high! However, there are companies which are trading in the Banking sector which have a P/E multiple of around 20. The simple reason is that the FMCG business is a lot more stable compared to the Banking business. The last thing which people will stop buying are groceries & day-to-day products which are produced by FMCG companies!
Another thing which investors keep in mind when analyzing the safety of their investment is the future of the sector. This is the reason why a sector such as the IT industry received a much higher P/E multiple compared to the Coal industry. The IT industry is expected to boom in the future & is seen as a sunrise industry whereas the Coal industry is expected to decline in the future & is seen as a sunset industry. Smart investors are willing to switch from low P/E multiple stocks in sunset industries to high P/E multiple stocks in sunrise industries for the security of their capital.
4. National & International Policies
Smart investors hate companies which are highly susceptible to government interventions. Imagine being a shareholder of a company & suddenly half of your business takes a tumble due to a change in the government’s policy! Nobody likes to invest in such companies due to the underlying threat of any changes in policies. Such sectors include the Cigarette & Alcohol industry where the taxes could be changed at any time, commodity stocks which are highly dependent on world events & policies, etc.
Many such stocks tend to be news based stocks and are almost always avoided by smart players. Therefore, such stocks often trade at a very low P/E multiple.
5. Undervalued stocks
Sometimes, if none of the above is true, then it is entirely possible that the stock is an undervalued stock. Few stocks become highly undervalued due to the negligence by most big funds, a growing brand which many big funds do not have a lot of faith in or maybe due to quiet accumulation by smart investors. Whatever may be the reason, there are always such stocks in the stock market which are undervalued by the investors & can prove to be a safe bet for investors in the future. Many such stocks become multibagger stocks in the future. If you want more multibaggers in your portfolio, visit this article – How can you get multibaggers in your portfolio?
The final decision of investing depends, however, entirely upon the reader. If you liked this article, share & subscribe to this website! Follow us on Twitter for quick notification!
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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