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Vikrant Sitani, CFA
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Vikrant Sitani, CFA is currently working at well known Financial Services Company. Vikrant holds MBA from Virginia Commonwealth University and is Chartered Accountant from India.
  • Perspectives On Price Earning (PE) Ratio 1 comment
    Feb 12, 2013 9:09 PM | about stocks: SPY, EMF

    Most analyst reports on stocks research contain references to Price Earnings (NYSE:PE) Ratio. Hersh Shefrin in his famous book "Behavioral Corporate Finance" has mentioned that investors use PE ratio as a shortcut to compare valuation for different companies. People rate stocks based on PE ratio, which is basically stock price divided by earnings per share. Amongst other things, High PE ratio implies that market expects earnings of the company to grow faster than companies with a lower PE ratio. It is common sense? What is new in this?

    Jeremy Grantham in his latest quarterly letter (gmo.com) has written extensively about how investors who invest in companies in emerging market underperform the market. These companies are quoting at a high PE ratio on the stock exchanges. It is not because that these companies or companies in the emerging markets don't grow. They underperform because the earnings don't grow faster than what is implied in the stock price.

    In their book "Valuation" McKinsey authors Tim Koller, Mark Goedhart, David Wessel have shown that companies when they acquire other companies always use Discounted cash flows (DCF) to value the companies and investors when they invest in stock market, don't consider DCF, probably because they are not able to link the two. For valuation of any asset, what matters is cash flows discounted to the present value using a rate which reflects the risk free rate and risk (more about risk in another blog). They have shown the relationship between Price Earnings ratio and DCF. Very few books have shown in detail the relationship between the DCF and PE ratio. They have used prominent companies and compared the valuation using DCF and PE ration and its subsequent share performance of the company on the stock exchanges.

    Many investors invest in stocks by looking at factors like brand names, price to book value ratio, recent price growth and PE ratio etc. Often the most important thing which is important for successful investing is knowing the value of the company. Even though it is common knowledge Daniel Kahneman, Nobel Prize economist in Thinking Fast and slow has written extensively that many well known institutional investors don't seriously factor the valuation when they make an investment.

    One of the main tenants of picking the stock is knowing the value of the company and the price one is paying for the stock. Price is what you pay and value is what you get. If one is buying a stock, with a high PE ratio, he should be aware, that for him to over perform the market; the company should earn profits higher than what is implied in the high price of the stock.

    Stocks: SPY, EMF
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    Author’s reply » Perspectives on Price Earning (PE) Ratio.
    12 Feb 2013, 09:10 PM Reply Like
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