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THE ART OF SELECTION - PART 1

 Someone once asked me - "How do you select a stock from the complete universe?". For me its a long journey and my infrequent blog posts bear testimony to it!. However its a journey worth undertaking to achieve satisfaction both intellectual and material. Well let me share it with you here and in subsequent parts.

 
Well begun is half won. Thats the importance of the first step. In many ways it is like anything first - first bike, first love. It stays with you for good or worse. For me it is PEPrice to earning ratio. For the lay investor, it equals the current market price divided by the Earning Per Share (NYSEARCA:EPS) . It comes in various shapes and sizes - 
 
Historic PE. This uses the EPS as given in the latest annual report and hence historic .i.e reflecting the previous financial years efforts. Using this puts one on a firm footing as the figures are - well, firm. The figures read over the past few years accurately reflect any cyclicality in the business, unless the business is cyclical within the year (like cement) in which case you would need a quaterly breakup of the EPS. I use it only as a start point of the analysis.
 
Forward PE. Along with Historic PE it completes the yin-yang pair. It is anything but firm as it includes some prediction, lots of (guess?) estimates and dollops of hope (and prayers, if given out by a young intern/analyst). This is used fairly late in the analysis when one has developed a finer sense of the business and is able to make reasonable assumptions of the revenue growth, operating and net margins and the general business environment.
 
TTM PE.  Trailing Twelve Months PE uses the EPS totalled for the last four quarters, regardless of the financial year. It gives a more realistic, accurate and current picture of the business. A favourite of mine (we all have our albatrosses, dont we?!).
 
Relative PE
On a stand alone basis, PE is just a number. Its relevance emerges only with relativity. Is PE of 5 low and 30 high? What if I say that oil and gas sector traditionally figures in single digits but telecom trades at higher than 20? So 5 and 30 are just numbers and ONGC@ 5 and Reliance Com@ 20 are like chalk and cheese. How about Reliance Com (30.44) and Bharti(21). So compare it relative to :-
  • Peers in the industry.
  • Its own historic values.
  • The PE of the index it is part of.
Any major variation must not be inexplicable. So why must Rel Com trade at a 45% premium to Bharti? Thats food for thought for you and a thought for another post for me. 
 
And last but not the least - there are situations where PE cannot be used - try comparing Cairn and ONGC by this metric.
 
In the next part of the series we shall delve into the bottom (line) - I meant the profit margins!
 
Happy hunting till then.