What is a p/e ratio ?What is a p/e ratio ?

formulae = share price/ epsformulae = share price/ eps

eps eps = earnings per share= earnings per share

= net profit / no. of outstanding shares.= net profit / no. of outstanding shares.

(I am sure u know this, but still !)(I am sure u know this, but still !)

What does it say?What does it say?

It tells me the number of years a company It tells me the number of years a company would take to return me my capital would take to return me my capital investment as profits. Which means investment as profits. Which means assuming the share price remains assuming the share price remains constant throughout the holding period, constant throughout the holding period, how much time will the co. take to double how much time will the co. take to double my investment. my investment.

for example:for example:

Infosys Technologies Infosys Technologies

Net profit – Rs.150Net profit – Rs.150

No. of shares – 3No. of shares – 3

EPS – Rs.50 EPS – Rs.50

CMP - Rs.1,500CMP - Rs.1,500

p/e - 30p/e - 30

Now if Mr. John were to buy one of the three shares, the Now if Mr. John were to buy one of the three shares, the other two being Bon and Tom. Note – there are no other other two being Bon and Tom. Note – there are no other shareholders. Which means all the profit will be shared shareholders. Which means all the profit will be shared by John, Bon and Tom. Right ? Yep. by John, Bon and Tom. Right ? Yep.

for example:…..contfor example:…..cont

What is the return on capital employed for Mr.John ?What is the return on capital employed for Mr.John ?

ROCE = (50/1500) = 3.33 %ROCE = (50/1500) = 3.33 %

Not a good investment by any measure, is it? Not a good investment by any measure, is it?

Bank deposits yield = 5.5 %Bank deposits yield = 5.5 %– p/e ratio for bank deposits can be calculated as – p/e ratio for bank deposits can be calculated as – – Investment – Rs.100Investment – Rs.100– Interest earned annually – Rs.5.5Interest earned annually – Rs.5.5– p/e ratio – 100 / 5.5 = 18.2p/e ratio – 100 / 5.5 = 18.2

Similarly p/e ratio can be calculated for bonds, or for that matter Similarly p/e ratio can be calculated for bonds, or for that matter any investment.any investment.

Two questions should emerge in your mind, viz.Two questions should emerge in your mind, viz.

One, When bank deposit is at a p/e of 18.2 and that of One, When bank deposit is at a p/e of 18.2 and that of Infosys Technologies is at 30, where should one invest ?Infosys Technologies is at 30, where should one invest ?

The obvious answer – YES, the bank deposit is a better option.The obvious answer – YES, the bank deposit is a better option.

– The most important reason being the ‘zero risk’ associated The most important reason being the ‘zero risk’ associated with banks or sovereign bonds compared to an Infy.with banks or sovereign bonds compared to an Infy.

– Also because the bank deposit yields more than Infy, 5.5% v/s Also because the bank deposit yields more than Infy, 5.5% v/s 3.3 %. This also implies that money invested in the bank 3.3 %. This also implies that money invested in the bank deposit would double in 13.1 years as opposed to 22 years deposit would double in 13.1 years as opposed to 22 years taken by an investment in Infy.taken by an investment in Infy. (Remember ‘rule of 72’. If not (Remember ‘rule of 72’. If not then – it says that the number of years taken by any then – it says that the number of years taken by any investment to double is equal to (72 / rate of interest) investment to double is equal to (72 / rate of interest) …..…..contcont

Answer to question no.1 – Answer to question no.1 –

Any rationale investor Any rationale investor ‘would not’‘would not’ put his put his money in an investment that is not only money in an investment that is not only riskier than a bank or a govt. but also riskier than a bank or a govt. but also gives him a lower return on investment.gives him a lower return on investment.

Questions…cont.Questions…cont.

Two, why do then people invest in Infosys and not in bank Two, why do then people invest in Infosys and not in bank deposits ?deposits ?

Well, this is because Infosys by virtue of being a business Well, this is because Infosys by virtue of being a business has the potential to increase its profits, and therefore its has the potential to increase its profits, and therefore its earnings per share, therefore its yield for its investors earnings per share, therefore its yield for its investors (John, Bon and Tom in this case).(John, Bon and Tom in this case).

As we all know the same is not the case for a bank or a As we all know the same is not the case for a bank or a govt. bond, right? And there in lies, the reason for people govt. bond, right? And there in lies, the reason for people investing in stocks such as Infosys (which have high p/e investing in stocks such as Infosys (which have high p/e and not with the ‘no-risk’ bank deposit or sovereign bonds.and not with the ‘no-risk’ bank deposit or sovereign bonds.

What does this potential mean for you and What does this potential mean for you and me as investors?me as investors?

– Recall the earlier numbers for Infy, Recall the earlier numbers for Infy, (YEAR I)(YEAR I) - - Net profit Net profit – Rs.150– Rs.150No. of shares No. of shares – 3– 3EPS EPS – Rs.50– Rs.50Share priceShare price - Rs.1,500- Rs.1,500p/e ratio p/e ratio – 30– 30

– Now assume that Infosys records a 100 per cent jump in its net Now assume that Infosys records a 100 per cent jump in its net profit the following year. profit the following year. (YEAR II)(YEAR II)

Net profitNet profit - Rs.300- Rs.300No. of sharesNo. of shares - 3- 3EPSEPS - Rs.100- Rs.100Share priceShare price - Rs.1,500- Rs.1,500p/e ratiop/e ratio - 15- 15

Looking at the Infosys share in the second Looking at the Infosys share in the second year makes it a better investment than the year makes it a better investment than the bank deposit, because not only does your bank deposit, because not only does your ROCE improve from 3.3% to 6.7%, your ROCE improve from 3.3% to 6.7%, your investment will now double in 10.8 years investment will now double in 10.8 years (compared to 22 years earlier) and better (compared to 22 years earlier) and better than bank deposit (13 years and ROCE of than bank deposit (13 years and ROCE of 5.5 %).5.5 %).

Year IIIYear III for Infy (PAT up 100%) for Infy (PAT up 100%)The numbers would now look something like this – The numbers would now look something like this –

Net profitNet profit - Rs.600- Rs.600No. of sharesNo. of shares - 3- 3EPSEPS - Rs.200- Rs.200Share priceShare price - Rs.1,500- Rs.1,500p/e ratiop/e ratio - 7.5- 7.5

– ROCEROCE - 200 / 1500 = 13.3 %- 200 / 1500 = 13.3 %– Years to doublingYears to doubling of inv. of inv. - 72 / 13.3 = 5.4 years.- 72 / 13.3 = 5.4 years.

John, Bon and Tom now have every reason to stay John, Bon and Tom now have every reason to stay invested in Infy forever. Even if it doesn’t grow from here invested in Infy forever. Even if it doesn’t grow from here they will be happier doubling their investments every 5.4 they will be happier doubling their investments every 5.4 years. Isn't it ?years. Isn't it ?

All this while we’ve assumed that the share price All this while we’ve assumed that the share price remains the same, i.e. the initial investment remains the same, i.e. the initial investment made by John, Bon and Tom.made by John, Bon and Tom.

John suddenly wanted to opt out of Infy because of John suddenly wanted to opt out of Infy because of some personal reasons so he decides to auction his some personal reasons so he decides to auction his share in Infy on share in Infy on www.xyztrading.comwww.xyztrading.com. How many people . How many people do you think will be willing to pay him Rs.1,500. My do you think will be willing to pay him Rs.1,500. My guess is every person on this earth. But John will sell it guess is every person on this earth. But John will sell it to only one person. So demand outstrips supply by a to only one person. So demand outstrips supply by a zillion, resulting in people bidding up the share price. To zillion, resulting in people bidding up the share price. To what extent would people bid it up……what extent would people bid it up……on next slide.on next slide.

The bidding would ideally continue till the point the The bidding would ideally continue till the point the ROCE is better than one from the bank deposit (plus ROCE is better than one from the bank deposit (plus some risk premium associated with a co.) In this case it some risk premium associated with a co.) In this case it should be around Rs.2,500 per share. ROCE = 8%, should be around Rs.2,500 per share. ROCE = 8%, which is still better than the bank deposit. So we have which is still better than the bank deposit. So we have people bidding for infy share at 8% return…some people people bidding for infy share at 8% return…some people may even be happier by getting 7% return…and may may even be happier by getting 7% return…and may drive up the Infy price even higher. But we assume that drive up the Infy price even higher. But we assume that the max. bid came in at Rs.2,500 per share. the max. bid came in at Rs.2,500 per share.

Remember the EPS in the third year is Rs.200 per share, hence the Remember the EPS in the third year is Rs.200 per share, hence the ROCE at 8% for a share price of Rs.2,500.ROCE at 8% for a share price of Rs.2,500.

Enter Enter Ms. FionaMs. Fiona, a security analyst with , a security analyst with www.xyztrading.comwww.xyztrading.com. According to her calculations . According to her calculations Infy will post a 100 per cent rise in net profit in year IV. Infy will post a 100 per cent rise in net profit in year IV.

The estimated calculations – The estimated calculations – (YEAR IV)(YEAR IV)

Net Profit Net Profit - Rs.1200- Rs.1200

No. of sharesNo. of shares - 3- 3

EPSEPS - Rs.400- Rs.400

CMPCMP - Rs.2,500- Rs.2,500

ROCEROCE - 16 % - 16 %

– Eureka, eureka !! Immediately she believes she’s got a Eureka, eureka !! Immediately she believes she’s got a great investment in Infy. One which will yield (16 % return great investment in Infy. One which will yield (16 % return per annum, compared to 5.5 per cent by bank deposit) per annum, compared to 5.5 per cent by bank deposit) and one which will double her money in a mere 4.5 years.and one which will double her money in a mere 4.5 years.

But there’s a problem. Both Bon and Tom would not sell But there’s a problem. Both Bon and Tom would not sell their share in the business their share in the business (remember we’ve only three (remember we’ve only three shares in this company).shares in this company). But the last buyer, who bought But the last buyer, who bought from John, Mr. Adam Smith may, however, be willing to from John, Mr. Adam Smith may, however, be willing to sell his share, provided he gets a better share price. Ms. sell his share, provided he gets a better share price. Ms. Fiona after thinking hard suggests a price of Rs.3,200 Fiona after thinking hard suggests a price of Rs.3,200 per share, 28 % premium to what Mr. Smith had paid to per share, 28 % premium to what Mr. Smith had paid to John. But, Mr. Adam Smith being a smart economist, John. But, Mr. Adam Smith being a smart economist, does his calculations and reverts to Miss Fiona with an does his calculations and reverts to Miss Fiona with an ask price of Rs.4,000. ask price of Rs.4,000.

Miss Fiona gets back to her numbers and feels Infy at Miss Fiona gets back to her numbers and feels Infy at Rs.4,000 may still be a good investment, yielding 10 % Rs.4,000 may still be a good investment, yielding 10 % per annum. Given the present low interest rate regime. per annum. Given the present low interest rate regime. She buys it from Adam Smith for Rs.4,000She buys it from Adam Smith for Rs.4,000

FIIs have been quite entry in the Indian markets but do FIIs have been quite entry in the Indian markets but do not seem to find any great investments. However, they not seem to find any great investments. However, they carry with themselves lots of knowledge of the sunrise carry with themselves lots of knowledge of the sunrise industries in the world, IT services being one of them. industries in the world, IT services being one of them. Back home in the US, they are increasingly hearing Back home in the US, they are increasingly hearing names like TCS and Infosys. names like TCS and Infosys.

They get classified information that Infosys is likely to get They get classified information that Infosys is likely to get a big order from General Electric, which would result in a big order from General Electric, which would result in Infy’s profits to grow by 100 per cent for the next two Infy’s profits to grow by 100 per cent for the next two

yearsyears..

Impact of this on Infy’s profitsImpact of this on Infy’s profits - -

Year VYear V Year VIYear VI

Net profitNet profit -- 2,4002,400 4,8004,800

No. of sharesNo. of shares-- 33 33

EPSEPS - - Rs.800Rs.800Rs.1600Rs.1600

Share priceShare price - - Rs.4000Rs.4000 Rs.4000Rs.4000

p/e ratiop/e ratio -- 55 2.52.5

We have a situation where the company’s yield at We have a situation where the company’s yield at current prices exceed 20 % in Year V and 40% in Year current prices exceed 20 % in Year V and 40% in Year VI.VI. But, our Ms.Fiona is unaware of this development But, our Ms.Fiona is unaware of this development and would probably sell her holding in Infy if good offer in and would probably sell her holding in Infy if good offer in put on table. put on table.

There are over a dozen FIIs willing to pay higher price for Fiona’s There are over a dozen FIIs willing to pay higher price for Fiona’s share in Infy. They all start bidding. Remember the share will share in Infy. They all start bidding. Remember the share will become unattractive when the ROCE on Infy share is less than 5% become unattractive when the ROCE on Infy share is less than 5% (this is because FIIs get 2% return in their own country, they would (this is because FIIs get 2% return in their own country, they would expect a risk premium from an Indian co. of around 3%).expect a risk premium from an Indian co. of around 3%).

As more and more FIIs bid, they all start discounting the expected As more and more FIIs bid, they all start discounting the expected earnings of Infy in Year VI (ie. EPS of Rs.1600). The final bid came earnings of Infy in Year VI (ie. EPS of Rs.1600). The final bid came in at Rs.25,000. (with an expected ROCE of 6.4 per cent in Year VI) in at Rs.25,000. (with an expected ROCE of 6.4 per cent in Year VI) Which is much better than most of the FIIs are getting in today’s Which is much better than most of the FIIs are getting in today’s scenario and infact interest rates may go down further in Year VI.scenario and infact interest rates may go down further in Year VI.

What this means for the Infy share in the current year –What this means for the Infy share in the current year –Net profitNet profit - Rs. 1200- Rs. 1200No. of shareNo. of share - 3- 3EPSEPS - Rs.400- Rs.400Mkt priceMkt price - Rs.25,000- Rs.25,000p/e ratiop/e ratio - 62.5- 62.5ROCEROCE - 1.6 %- 1.6 %No. of yrs to doubleNo. of yrs to double - 45 years.- 45 years.

Although Infy is not a sound investment if a person is Although Infy is not a sound investment if a person is looking at one year’s perspective but if the company’s looking at one year’s perspective but if the company’s net profit is going to grow by 100 per cent for the next net profit is going to grow by 100 per cent for the next two years than the Rs.25,000 paid now would look good two years than the Rs.25,000 paid now would look good investment two years from now investment two years from now (Year V ROCE = 3.2%, (Year V ROCE = 3.2%, Year Vi ROCE = 6.4 %, compared to an estimated Year Vi ROCE = 6.4 %, compared to an estimated interest rate of 4.5% in Year VI in India and a mere 1.25 interest rate of 4.5% in Year VI in India and a mere 1.25 % in the US).% in the US).

Conclusion – An investor is willing to pay 62.5 times (pe Conclusion – An investor is willing to pay 62.5 times (pe ratio) of Infy’s current years earnings to gain healthy ratio) of Infy’s current years earnings to gain healthy returns in the future.returns in the future.

What happens if the GE order for What happens if the GE order for Infy is half its estimated size?Infy is half its estimated size?

Year VYear V Year VIYear VI

Net profitNet profit -- 1,8001,800 2,4002,400

No. of sharesNo. of shares-- 33 33

EPSEPS - - Rs.600Rs.600Rs.800Rs.800

Share priceShare price - - Rs.25,000Rs.25,000 Rs.25,000Rs.25,000

p/e ratiop/e ratio -- 41.6741.67 31.2531.25

ROCE (est)ROCE (est) -- 2.4%2.4% 3.2%3.2%

– THIS IS LESS THAN THE REQD 6.4 %THIS IS LESS THAN THE REQD 6.4 %

The FII dumps the share as the size has turned out to The FII dumps the share as the size has turned out to lower than his estimates. So now when others bid for the lower than his estimates. So now when others bid for the Infy share they would include the effect of the GE order.Infy share they would include the effect of the GE order.

The new share price on offer in the market is Rs.12,500 The new share price on offer in the market is Rs.12,500 per share ( or 6.4 per cent estd. ROCE for the year VI). per share ( or 6.4 per cent estd. ROCE for the year VI).

What this means for the Infy share in the year IV (or the current year) –What this means for the Infy share in the year IV (or the current year) –Net profitNet profit - Rs. 1200- Rs. 1200

No. of shareNo. of share - 3- 3

EPSEPS - Rs.400- Rs.400

Mkt priceMkt price - Rs.12,500- Rs.12,500

p/e ratiop/e ratio - 31.25- 31.25

ROCEROCE - 3.2 %- 3.2 %

No. of yrs to doubleNo. of yrs to double - 22.5 - 22.5 2020years.years.

Final ConclusionFinal Conclusion

PE ratio is generally an indicator of the markets expectation of a company’s future PE ratio is generally an indicator of the markets expectation of a company’s future earnings. Higher the PE ratio, higher the expectation. Infosys, Wipro and TCS all earnings. Higher the PE ratio, higher the expectation. Infosys, Wipro and TCS all trade at PE ratio of 30+ this is because the company’s are expected to report 30+ trade at PE ratio of 30+ this is because the company’s are expected to report 30+ profit growth in the foreseeable future.profit growth in the foreseeable future.

High growth stocks tend to have high PE ratios because lot of expectations are built High growth stocks tend to have high PE ratios because lot of expectations are built in their stock prices. But growth stocks are also the ones with highest risk as if the in their stock prices. But growth stocks are also the ones with highest risk as if the growth is not realized the PE’s of these stocks tend to fall with the strongest of growth is not realized the PE’s of these stocks tend to fall with the strongest of gravitational forces.gravitational forces.

Contrary to IT companies, TISCO which reported over 100 % growth in net profits last Contrary to IT companies, TISCO which reported over 100 % growth in net profits last year is trading at a PE ratio of around 7-8. This is because it belongs to the year is trading at a PE ratio of around 7-8. This is because it belongs to the infrastructure sector where growth is often directly co-related to the GDP growth. infrastructure sector where growth is often directly co-related to the GDP growth. Hence u would find PE ratio of all infrastructure related industries to be near 6-10. Hence u would find PE ratio of all infrastructure related industries to be near 6-10. And the current growth in net profit is an aberration which will eventually correct when And the current growth in net profit is an aberration which will eventually correct when steel prices head down-south. steel prices head down-south.