Are low P/E stocks cheap ?

We have already discussed how to calculate P/E for wipro and Infosys. Now lets go one step further and see what actually drives P/E - either low or high.


We often hear people saying stock ‘X’ is cheap because it is trading at lower multiple or is expensive because its trading at a very high multiple compared to industry average. Is that really true? I hope after reading this you should have necessary tools at your disposal to be informed investor and ask back your financial advisor with the necessary information.

Drivers of P/E

Last time we calculated wipro and Infosys P/E to be 20.15 and 22.8 respectively. Before we jump to conclude which is cheap or expensive, we should understand what drives the P/E of an asset.

You will be surprised that there are only 3 parameters that drive P/E and you have heard about them:

1. Payout ratio – This determines how much a company is required to retain cash from its earnings for reinvestment purpose. Keeping other things constant, if a company needs to retain more capital relative to its competitor to achieve similar growth, the company is relatively inefficient.

2. Cost of equity – This is the return that equity investor expects from a stock. How do we determine this? Every stock is associated with a beta, which determines the riskiness of that stock. And as the saying goes higher the risk higher is the return investor expects. This implies higher beta is associated with higher cost of equity.

3. Lastly, the growth of its earnings. I think I don’t need to do any explanation on this.

Relationship between drivers and P/E

P/E = (payout-ratio)/(cost of equity-growth)

So what an investor should look for:

1. Payout ratio: Keeping others constant (meaning cost of equity and growth are same), companies with higher payout ratio should trade at a higher multiple and vice versa.

2. Cost of equity: Keeping others constant (meaning payout ratio and growth are same), higher cost of equity stocks should trade at a lower multiple.

3. Growth: Keeping others constant (payout and cost of equity are same), companies with high growth should trade at a higher multiple.

As an example, we will run this model through wipro and Infosys example.

Infosys drivers

(Source: in.reuters.com)

Beta: 0.54

Payout ratio: 22.46

Growth: 11

Wipro

Beta: 0.92

Payout ratio: 15.03

Growth: 9.31 (go to estimates and look for mean of long term growth)

So what do you observe comparing 3 drivers?

Wipro has lower growth, lower payout ratio and higher beta(high cost of equity), resulting in all drivers favoring Infosys to have higher multiple. Therefore Wipro deserves to be trading at lower multiple than Infosys.

But there exist stocks stocks which are cheap and do trade at lower multiple. The point is that now you have the tools required to discern between stock being cheap or deserving to be trading at lower multiple.

So is this the end of story. Not really… Even if we identify wipro deserves to be lower than Infosys, the question is by how much. I have seen analysts randomly slapping a multiple, with no justification.

A good analyst is expected to quantify all such details before recommending any stock to be cheap or expensive. I will try to address this issue later in the series.

But for now you may want to run this model through stocks you know. Happy P/E ….