The Ideal P/E Multiple For A Stock Is...

Warren Buffett’s fortune is enough to stupefy anyone. Starting from scratch, he has amassed a fortune of billions and billions of dollars. And the most amazing part of that feat is not even that – it is the fact that he has achieved so much wealth in his lifetime purely by investing in the stocks and bonds of companies.

As he has mentioned a number of times, he credits much of the framework with which he invests to Benjamin Graham, his mentor and teacher from whom he learned how to invest. Thus, it should be of immense interest to anyone who wants to invest wisely, to hear what Graham has to say on the subject of the maximum price one should pay for buying a stock. After all, this is a perennial question that comes to the mind of investors – What is the right price to pay?

For the purchase of a stock to be successful, every investor relies on future earnings of the company and not its past earnings. But at the same time, Graham was of the firm opinion that when evaluating a stock and its future earnings, one can be conservative only by basing this opinion on company’s actual performance over a period of time in the past. Thus, in most cases, the investment (and not speculative) value of stock can be arrived at by taking into consideration the company’s average earnings over a period of five to ten years.

The company’s profit in the most recent year may be taken as the base for arriving at the value in some cases, but only if it meets the following criteria –

(1) general business conditions in that year were not exceptionally good

(2) the company has shown an upward trend of earnings for some years past

(3) the investor’s study of the industry gives him confidence in its continued growth

And only in the extremely rare and exceptional case should one rely on the assumption of a company achieving higher earnings in the future while calculating the price one pays. Higher future earnings should be taken into consideration only if it is a 100% sure thing, which is very rarely the case.

The above was a discussion of Graham’s suggestion of which earnings should one take as the base when valuing a company by using a P/E ratio. Now for the second part – what would be the right multiple one should give those earnings to arrive at the price one should pay for the stock?

A conservative investor may rightfully give a very attractive company a higher multiple. This may be a company whose latest earnings are above its past average, which has extremely promising future prospects, or has an inherently stable earnings power. However, at the very heart of Graham’s argument was his opinion that there must always, in every case, be some upper limit of this multiple that is assigned to the stock in order to stay conservative in one’s valuation. He suggested that about 20 times average earnings is the highest price that can be paid buying a stock from an investment perspective. While this is the maximum one should pay for a company considered to have very good prospects, about 12 or 12.5 times average earnings would be suitable for the typical company with average prospects. This is because investment, as opposed to speculation, necessarily requires demonstrated value, which can be verified only by way of average earning power in the past. A P/E multiple of 20 in effect means an earnings yield of 5% (1 divided by 20).

It would indeed be very hard to conservatively justify average earnings of less than 5% of the market price of a stock without betting your money on an increase in earnings of the company in the future. Thus, according to Graham, a price to earnings ratio of higher than 20 times average earnings cannot by any means provide the margin of safety that an investor should have. It might be accepted by an investor in expectation that future earnings will be larger than in the past. But such a basis of valuation would then have to be termed “speculative”. That is because speculation derives its basis and justification from potential developments that differ from past performance.

By the above thumb rule of not paying more than 20 times average earnings, Graham did not imply that it would be mistake to do so. He suggested instead that such a price would be speculative. Further, it should also be noted that such a purchase can easily turn out to be highly profitable, but in that case it will have proved to be a merely fortunate speculation. And very few people are consistently fortunate in their speculation.

Hence people who habitually purchase stocks at more than about 20 times their average earnings “are likely to lose considerable money in the long run” according to Graham. This is all the more likely because if such a mechanical check were not enforced, investors have the tendency to time and again give in to the temptation and lure of bull markets, which always find some or the other deceptively pleasing argument to justify paying extravagant prices for stocks.

Investing in an IPO !! Steps how to analyse

Here is a simplified idea of how to analyse initial public offerings (IPOs) using technical and fundamental analysis.
There have been raging discussions during the past three years, both, when the Indian IPO market was booming and when it was crashing.
Should we invest in IPOs or rather buy the stock when it comes to the secondary market? The debate over this a long-drawn one with varying answers during boom and bust.
This article will try to give some tools and ratios, which help us decide whether to invest in an IPO or not at any time!
Analysis based on market value (market cap)
Market value in the case of an IPO can be defined as the number of shares available for subscription multiplied by the price per share plus the price per share multiplied by outstanding shares if any.
In the case of analysis, when there is a price band available, it's advisable to do the analysis based on the lowest price.


check 1: Price to Sales (P/S) ratio
This number is derived by dividing the market value by the value of annualised sales. It can also be derived by dividing the price of a share by the sales per share. It is basically an indication of the amount the company is trying to garner from the market vis-a-vis its current business.
A rule of thumb for the P/S ratio when deciding on IPO investment is that lower the P/S ratio the better it is as an investment.
A word of caution is that it should not be the only parameter before deciding.

Check 2: Price to Earnings (or Loss) P/E ratio
This number is derived by dividing the market value by the annualised profits (loss) for the company. It is an indicator of the number of multiples that the market is ready to pay for the stock over its current profit levels.
If the profit is Rs 2,500 crore (Rs 25 billion) and number of equity shares is 1,000, then the P/E is 2.5. Meaning, the market is ready to pay 2.5 times the profit per share to buy the stock.
Thumb Rule for P/E with respect to IPOs
The lower the P/E, the better it is for the investor. In simple terms, a lower P/E means, you are getting to buy something that has the ability to reap high benefits at a very cheap price.
The irony is that during boom times uninformed investors get carried away by high P/E multiples.


check 3: Price to Book value (P/B) ratio
The book value is defined as the difference between total assets and liabilities. In a more crude way, it is also defined as the amount that will be left back after paying all liabilities in case of a closure.
The P/B of an IPO is calculated as market value divided by the book value. It gives an idea on what value the market places on the stock based on its books.
Thumb rule: Lower the P/B the better. It would be advisable for a potential IPO investor to look for IPOs with low P/B. Some of these stocks are called value stocks.
Long-term investors buy such companies and hold on to them till they slowly but steadily grow their business till a day when the share prices might shoot up phenomenally and then exit with huge profits.

Check 4: Price to Tangible Book Value (PTBV) ratio
This number is derived by dividing the market value by the tangible book value. The Tangible Book Value (TBV) is equal to the book value of the company minus the intangible assets.
Intangible assets are those that cannot be seen or felt. Examples include IP rights, goodwill patents, etc. Similar to P/B, it can also be crudely seen as the amount an investor would get if the company ceases to exist and all its assets have to be sold.
The reason it is seen separately is that most intangible assets would be very difficult to sell in case of closure.
Thumb rule: Lower the PBTV the better. A PBTV of 0-1.0 (zero to one) means the company is trading at or below the worth of its own tangible assets. Once the mark crosses one, the risk for the investor too is proportionally higher.
In case of certain companies the PBTV could be negative too.


check 5: Gross margin percentage
The gross margin percentage is derived by dividing the gross margin of the company (the margin before accounting for taxes, depreciation, expenses, etc) by the total value of sales. This gives an idea of what is the percentage of margins for any value of sales.
Thumb rule: Higher the gross margin the better. This in simple terms indicates that the company's product of service has a good margin of income. The higher the gross margin, the better would be the actual profit. For certain industries where costs are very high the gross margin percentage would be low.
In such cases, we need to analyse if it's higher than for other competitors in the same domain of business.

Check 6: Profit margin percentage
This number is derived by dividing the profits by total value of sales. Again, as in the case of gross margin percentage, higher the profit margin percentage, the better it would be to invest in the IPO of that company.
A word of caution, though. The gross profit margin percentage and the profit margin percentage should be analysed for at least 3-4 years to check for consistency.
Some companies might show higher margins due to one off reasons which might not hold true after the IPO.
All the above calculations need to be taken into consideration along with the analysis of the company's management, its business model, the sustainability of its product/service and other such fundamental parameters while deciding to invest in an IPO or not.