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12 June 2009

THE ART OF SELECTION - PART 1

Someone once asked me - "How do you select a stock from the complete universe?". For me its a long journey and my infrequent blog posts bear testimony to it!. However its a journey worth undertaking to achieve satisfaction both intellectual and material. Well let me share it with you here and in subsequent parts.

Well begun is half won. Thats the importance of the first step. In many ways it is like anything first - first bike, first love. It stays with you for good or worse. For me it is PE. Price to earning ratio. For the lay investor, it equals the current market price divided by the Earning Per Share (EPS) . It comes in various shapes and sizes - 

Historic PE. This uses the EPS as given in the latest annual report and hence historic .i.e reflecting the previous financial years efforts. Using this puts one on a firm footing as the figures are - well, firm. The figures read over the past few years accurately reflect any cyclicality in the business, unless the business is cyclical within the year (like cement) in which case you would need a quaterly breakup of the EPS. I use it only as a start point of the analysis.

Forward PE. Along with Historic PE it completes the yin-yang pair. It is anything but firm as it includes some prediction, lots of (guess?) estimates and dollops of hope (and prayers, if given out by a young intern/analyst). This is used fairly late in the analysis when one has developed a finer sense of the business and is able to make reasonable assumptions of the revenue growth, operating and net margins and the general business environment.

TTM PE.  Trailing Twelve Months PE uses the EPS totalled for the last four quarters, regardless of the financial year. It gives a more realistic, accurate and current picture of the business. A favourite of mine (we all have our albatrosses, dont we?!).

Relative PE
On a stand alone basis, PE is just a number. Its relevance emerges only with relativity. Is PE of 5 low and 30 high? What if I say that oil and gas sector traditionally figures in single digits but telecom trades at higher than 20? So 5 and 30 are just numbers and ONGC@ 5 and Reliance Com@ 20 are like chalk and cheese. How about Reliance Com (30.44) and Bharti(21). So compare it relative to :-
  • Peers in the industry.
  • Its own historic values.
  • The PE of the index it is part of.
Any major variation must not be inexplicable. So why must Rel Com trade at a 45% premium to Bharti? Thats food for thought for you and a thought for another post for me. 

And last but not the least - there are situations where PE cannot be used - try comparing Cairn and ONGC by this metric.

In the next part of the series we shall delve into the bottom (line) - I meant the profit margins!

Happy hunting till then.

18 comments:

Manish Chauhan said...

Nice one Puneet .

Where do we get info for all kind of PE !! . Or Do we have to work hard on our own ? I hate it :)

Manish
http://www.jagoinvestor.com

Puneet said...

Thanks Manish.
For the values one has to scrounge around. I still havent found a one stop shop (which is free!) for PE.

sumi said...

Hi Puneet, Screening companies based on P/E matches well with my investing philosophy as well. Comparison between peers and using historic estimates is the way to go about selecting a company. It is also useful to understand the market sentiments around a fundamentally sound stock. I would like to hear your views about stocks which have a P/E close to one. What is the next important factor to screen after that. I use P/BV, Net Sales, EPS and a few more.

Rk said...

Hi,

Thanks for starting this series.

Sometimes we may find negative EPS. In this situation PE becomes -ve or +ve ?
How to make decisions in such cases ?
Is there any significance for negative PE?

Sorry If I have posted a wrong question.

Thanks
Rk

Puneet said...

@ Sumi,
Thanks for the comment.
Market sentiment is a beast which in my humble opinion best left un-holstered. There is no way to objectively measure sentiment. In the long run its the sentiment which comes round to the fundamentals and not the vice versa.

PE close to 1 can mean ( on the face of it) two things - its an undiscovered story or the less appealing (and hence more probable) that it deserves to be there. However does not apply to new companies.

The next factor as I have mentioned in my post is Profit Margin.

Puneet said...

@ RK
The best questions are often asked by people with open minds, like yours.
Negative EPS means a loss making company. So the PE multiple cannot be used to value it. One would have to take a call on the business - a subjective assessment. Sometimes the best of them have a negative EPS e.g Bharti in 2001/02 and Cairn in the last fin year.

Rk said...

Puneet, Thanks For your reply.

what is the difference between Adjusted and Reported EPS ?
Data from Raymond Ltd
PER SHARE RATIOS Mar ' 09 ,Mar ' 08,Mar ' 07,Mar ' 06,Mar ' 05 , ,

Adjusted E P S (Rs.) 7.55,-0.14,6.47,13.76,10.49
Adjusted Cash EPS (Rs.) 22.02 ,13.06 , 16.74 ,25.61 ,20.88
Reported EPS (Rs.) -44.05 ,10.77 , 32.79 ,19.92 , 12.51
Reported Cash EPS (Rs.) -29.58 ,23.98 , 43.06 ,31.77 , 22.90

Why there is such difference between them ?

Thanks
Rk

Puneet said...

A reported EPS is one declared by the company in its filings. An analyst, in order to have a better understanding of the reported figures 'adjusts' the EPS to account for extraordinary items e.g sale of an asset during the year, which is unlikely to reoccur frequently in future (sale of land etc) would artificially enlarge the EPS.

Charu Gupta's Blog said...

Hi Puneet,

Well written. Guess what, even I'm going to write a post on about my investment strategy. I like the way you have started the series. Very informative. Will look forward to the series.

Regards,
Charu Gupta

Puneet said...

@ Charu,
Thank you for the comment. Looking forward to reading your post.

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