Price to earnings
The P/E ratio measures the price the market is willing to pay for every rupee of a company's earnings.
P/E = Market price per share / Earnings per share
- Read as a multiple: a stock at a P/E of 12x trades at twelve times its earnings.
- Price 240 and EPS 12 give a P/E of 20x.
A P/E built on historical earnings is of limited value. Prices change every second while reported earnings update once a quarter, so the price keeps moving after the last EPS is known, in anticipation of the next one. If earnings are expected to grow, the market pays a higher multiple per rupee of current earnings. The useful question is therefore the prospective one: how much of the future is the current price already discounting?
An analyst says a company trades at 20 times this year's earnings but only 15 times next year's, given the state of its order book. Both multiples share the same numerator, the current price. The denominators differ: next year's projected EPS is higher than this year's, so the forward P/E is lower. The gap is the growth the market expects. Read the two together and treat either alone with caution.
Most publications show P/E on historical earnings from the latest quarterly reports, because analysts' forecasts are not widely available and vary; some report a consensus estimate. The P/E of an index is used to judge whether the whole market is expensive: it rises when prices run ahead of earnings and falls when a correction brings uncertainty about future profits. A value investor looks to buy when the P/E is low.
The syllabus says a stable, large, well-known company will usually command a higher P/E than a smaller, riskier one in the same sector, then immediately warns this is not gospel. A smaller company with strong growth expectations can trade at a higher multiple than the large stable one. Do not pick an answer on size alone.
Price to sales
P/S = Current market price / Annual net sales per share or P/S = Market capitalisation / Annual net sales
- Annual net sales of 1 crore over 10 lakh shares is 10 rupees of sales per share; at a price of 40 the P/S is 4.
All else equal, a lower P/S than peers suggests relative undervaluation, but the market may assign a premium or discount for future profit potential and for financial and other risks. A drop in the revenue growth rate is a high risk for stocks valued this way. The ratio's particular use is in industries going through a phase of losses, where an earnings multiple is meaningless because there are no earnings. Like every multiple, it belongs alongside other data and peer comparison, never alone.
Price to book value
P/BV = Current market price / Book value per share, where Book value per share = Net worth / Number of shares outstanding
- Net worth is share capital plus reserves and surplus.
- Capital 10 lakh plus reserves 50 lakh is a net worth of 60 lakh; over 6 lakh shares the book value per share is 10; at a price of 20 the P/BV is 2x.
Book value per share is the accounting value of net worth per share. Its limitation is that most assets sit on the books at historical cost less depreciation, not at what they would fetch. For a company that has built reserves through sustained profitability it is nonetheless an important indicator of value.
A P/BV below 1 means the share trades below its book value and is deemed undervalued. The syllabus insists on the follow-up question: why is the market pricing the share below book? Poor past investments that will need to be written down are one reason. Not every stock at a discount to book is a bargain.
It values companies whose earnings are negative, when P/E cannot be used. It compares companies within an industry where accounting standards are consistent. It suits banks and financial institutions, whose balance sheets carry liabilities and monetary assets largely valued at going market prices. It is weak for sectors such as services, where assets are limited, and less telling for companies whose asset side is mostly depreciable tangible assets and amortisable intangibles.
Differential voting rights
A DVR share is like an ordinary share except that it carries fewer than one vote per share. Issuers use it to raise capital without diluting voting control; investors who care about dividends and capital appreciation rather than votes find it attractive. The number of votes per DVR varies by company. DVRs trade as a separate category of instrument, typically at a discount to the ordinary shares. The Companies Act 2013 sets the eligibility: a dividend of at least 10% over the preceding three years, and DVR shares not exceeding 25% of the total post-issue paid-up capital. Tata Motors and Pantaloons are the syllabus's examples of past issuers.
- P/E is market price divided by EPS: the rupees paid per rupee of earnings. Historical P/E is of limited value because prices move on anticipated earnings; forward P/E uses projected earnings and is lower than current P/E when growth is expected.
- P/S is price over annual net sales per share, or market cap over annual net sales. Useful when profits are negative; a drop in revenue growth is the big risk.
- P/B is price over book value per share, where book value per share is net worth divided by shares. Below 1 means trading under book, which may or may not be a bargain. Suits banks and financial institutions; weak for asset-light services.
- A DVR share carries fewer than one vote, lets issuers raise capital without diluting control, trades at a discount, and under the Companies Act 2013 needs a dividend of at least 10% in the preceding three years with DVRs capped at 25% of post-issue paid-up capital.