Initially – as a Novice Investor – I use to value and compare companies on the basis of PE ratio. Unfortunately, I was wrong.
It’s the most disastrous means of valuation metrics. Yup! The Most Overrated Criteria to Value a Stock. I’ve got a point.
Look at the numbers (especially PE ratio) of Pharma stocks:
All the other industry stocks have more than 25 PE ratio but Torrent Pharma, despite being a good business, doesn’t have the perfect valuation.
If you think, somewhat similar to the text encrypted above, in the box then it’s injurious to your financial health.
Torrent Pharma have a Cash PE of around 36 and its normal PE ratio is 17. That’s a difference of about 50% and it’s wide enough to change the mind of any rational Investor.
PE ratio can be highly manipulative and be relying highly on this destructive valuation metric may affect your investment returns to a great extent.
Generally, stock with 10 PE is considered cheaper as compared to stock with 20 PE but it’s not the right way of valuation.
Here’s the shock:
A company which had never ever touched the PE valuation below 20 can still be a good investment and another company which had never touched the mark of 10 PE ratio can also be a bad investment.
PE is highly used by many analyst and fellow investors but there is a huge flaw in this ratio.
A company with low growth prospects reflects low PE (cheap) and company with high growth future attracts high PE ratings (expensive).
Like Tech companies have good future growths so people are ready to pay more to this sector as compared to textile companies.
Tech Industry PE – 20 AND Textile Industry PE – 10
That’s the difference of half/double.
People are ready to pay 20 INR for 1 INR earning in Tech and in textile, 10 INR for 1 INR.
Is there any alternate of PE which considers growth?
Yes, PEG ratio but again, it is a biased ratio. The formula is PE/Growth rate and growth rate is an “assumed value” which means that the rate will be biased based on the factor that evaluator consider and of course, it will change from one person to another.
Another flaw associated with PE ratio is that it’s not the great fit to compare stocks from the different sector. Hence, earning is not the perfect metric to evaluate the stock. It has many drawbacks.
The whole hypocrisy starts with the advent of accrual accounting system. As per accounting norms, Accrued income is an amount that has been 1) earned and 2) there is a right to receive the amount.
A quick example:
For a sec, just imagine……. On 1st January, you invested 1 lakh cash in Fixed Deposit @10% returns paid annually.
My question here is – What will be your interest income at the end of second quarter (i.e. June end)?
Nothing, as the interest will be paid annually so you didn’t receive any money yet.
It’s absolutely correct if the calculation is done on the basis of cash-based accounting system but, my friend, as per accrual based system your accrual income will be 5% of the amount invested as you are entitled to receive 5% of interest by lending money for a whole half year.
The books (if any) will record this as an income even if you didn’t receive the actual cash.
In the same manner, the company is restricted to use Accrual based accounting.
It includes all the income which company has not yet received but are entitle to receive. This is the biggest flaw associated with PE ratio as it is calculated by considering the manipulated Earnings.
The earning may be high even if the company didn’t receive any cash.
Let us peek inside balance sheet of an EPS manipulative company – INOX WIND.
It is an Indian wind energy service provider. Headquartered in Noida, India, the company is a subsidiary of Gujarat Fluorochemicals Limited.
From past few months, people are highly bearish on this stock. It lost its value by more than 50% since its listing on 10th April 2015. It’s one of the worst IPO performers in 2015, now also in 2016.
But one thing panicking me inside is – Why the heck company lost its valuation despite giving good quarters/annuals & increase in revenue/profits?
Look – how the company revenue and profits are increased:
Image – screener.in
But if you came over one of my previous article onthen you’ve completely outsourced this part of the problem.
There I stated – Around 50% of the total income of Inox Wind is accrual that means that only 50% of the total sales is actually received in cash, rest are just Trade Receivables.
So sometimes earnings are also manipulative. Don’t consider it as the primary criteria. There are many other to be considered.
This also works in opposite direction, that is……
Earning can be low even if the company received a high amount of cash earning.
Let’s have a look at some other companies – following is an image from valueresearchonline.com:
Now, you can easily figure out the difference between cash and actual EPS in many reputed companies.
What type of expenses does Accrual income includes which drive down profit despite no cash outflow?
- Research and development
- Other non-cash expenses
At times, this can be misleading and you might overlook a good investment opportunity due to an artificially high P/E ratio.
Upon them, depreciation is one of the most frequent seen non-cash expenses. SO prefer Cash EPS in place of Actual EPS.
How should you calculate Cash EPS?
This is the formula of Actual EPS = Actual earning/Total no. of shares.
Now just add some more components to numerators:
Cash EPS = (Actual Earning + Depreciation + any other non-cash expense)/Total number of shares
Note: The term “Net Profit” is alternatively used in place of “Actual Earning” in accounting books.
Why are company enforced to use Accrual based Accounting System?
Because there is no alternate.
The cash-based system is even more flawed than Accrual. If the cash basis system is followed then we will not able to get a clear picture of company’s working.
Like Infra related company incur a huge amount of cash outflow at their initial stage of projects whereas their profit is spread away in many different years.
Just imagine how awful their books will look like with cash loss in one year and then profits in future years.
Same thing happens with Pharma related companies. They incur huge cash outflow in research and development at their initial stage and then inflows are spread away in different years.
That is why, infra and pharma companies can show their initial year cash outflows as depreciation or R&D expenses respectively at later year accounting books, despite no cash outflow occurred in later years.
That is why accrual-based accounting is enforced by law to create some amount of P&L equality in different years. Still, accrual based accounting has its own flaws which we discussed above.
The clever Investor is the one who understands & detects the legal manipulations in the books and thereafter form his sound investment decision.
Here’s a paragraph from the book – The Tao of Warren Buffett:
There are many ways to describe what is going on with business but whatever is said, it always comes back to the language of accounting. When Warren was asked by the daughter of one of his associates what course she should study in college for investments, he replied, “Accounting – it is the language of business.” To read a company’s financial statements you need to know how to read numbers. To do that you need to learn accounting. If you can’t read the scoreboard, you can’t keep score, which means that you can’t tell the winners from the losers.
So always remember, Accounting is the language of Business. To understand a business, you need to have some amount of understanding of Accounts and its norms. Don’t get overwhelmed with manipulated shitty numbers. First, understand the whole system and then Invest.