Published by Gulshan Sachdev on 22/03/2019 at 10:09 PM

Why low PE does not guarantee value buying?

Continuing to the example of coffee shop in “What is Price to Earning Ratio”, having annual earnings of 1.2 lacs which cost you 12lacs. PE for this business is 12/1.2 = 10

Now once you took over the business you increased the profit to 2.4 lacs from 1.2 lacs.

Hence the new PE will now be of 5 i.e 12 lac revenue/ 2.4 lac annual profit. Seeing your growth, another person say owner 2 gets interested in buying your business and you want to make him an offer. 

Here you can add various cost heads like asset cost, brand value or client base, future earnings of 3 years etc, or you can simply use the same logic which was used while you bought the business. Meaning, you bought the business at PE of 10, hence you will sell your business at PE of 10. i.e. 10 times its current earnings

So you will sell your business at 24 Lacs (PE of 10 x 2.4 Lac per year)

Now for owner 2:  PE 2 would be 24 Lacs/ 2.4 Lac = 10

So he is happy that he got the business at industry PE, as all other coffee businesses were available at PE of 10 or even more

But soon he is not able to maintain this 2.4 lac profit per year, instead his business is now generating profit of only 1.2 lacs per year. This may happen due to price competition or drag in demand or due to mismanagement.

Hence the updated PE for owner 2 becomes = 24 Lacs /1.2 = 20

Now he is not able to run the business at 20 PE, hence he decides to sell it!

He approaches owner 3, Owner 3 is not ready to pay 24 Lacs for his business which is generating only 1.2 Lacs per year i.e. he is not ready to buy the business having PE of 20!

Owner 3 agrees to buy the business only at industry PE of 10. So as per industry PE of 10, the value of current business comes out to be 10 x 1.2 = 12Lacs

Owner 2 does not have any other alternative so he decides to proceed with the sale by booking loss. Owner 3 is now the new owner who has paid 12 lacs for a coffee shop which generates 1.2 lacs profit per year (i.e. PE of 10). 

During this entire change in ownership you might have noticed that all owners bought the business at same PE, but not all owners were in profit. Hope by now you have realized theimportance of earnings, historical PE of company, and industry PE.

Learning’s

Generally PE is maintained at historical average. Hence when Earnings increases the CMP should move up, so as to maintain the historical PE of business.

Likewise, as earnings drops, CMP should come down to bring the PE to its historical average.

Buying at low or average PE, wont guarantee value buying or success in share market

Its not the historical PE, rather the scope of earnings growth which matters the most. Hence, even though owner 2 bought the business at industry PE (10), he still booked loss. Because at the time he bought the business, the earnings were not sustainable Hence we should look for the potential growth in company rather than its current earnings which may beat its peak but it may not be sustainable. Every company have business cycles.There are peak years and there are slumps. We should ensure we don’t buy shares when sales are exhausted.