Low P/E should not be only reason for stock picking
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Stocks with low price to earnings (P/E) ratios always attract investors. Many stock pickers believe that companies with low P/E ratios are safe bets, especially if they have good performance and dividend paying record.
There are around 60 stocks in BSE 200 quoting at a P/E ratio of less than 10, as compared to the BSE Sensex which trades at a P/E of 15.91.
For example, MRF quotes at a P/E of 7, REC and CESC at P/E of 6, Bank of Baroda at 5.5 and Aditya Birla Nuvo quotes at a P/E of 9. "A low P/E can be used as a starting point since there is a margin of safety.
Besides that, check for things like growth potential of the company, the industry (sector) it belongs to, and issues relating to corporate governance before taking a final decision. Companies in certain industries like textile, commodities and manufacturing traditionally command low P/E ratios.
Take the case of commodity companies. Commodity prices are cyclical in nature. Prices go up or down based on a host of global factors, so does the profitability of companies dealing in those commodities. Profits could fluctuate and due to this lower valuations are given.
You will find that companies like Hindalco and Tata Steel, all primarily commodity players, command a lower P/E ratio. Hindalco commands a P/E of 9.2, and Tata Steel has a P/E of 7.1. The two companies come from reputed groups namely the AV Birla Group and the Tata Group, respectively. "One has to understand how much new capacity addition is happening in fixed asset across the globe.
Similarly, in the banking space, PSU banks like Bank of Baroda or Punjab National Bank have low P/E ratios. "There is a risk that restructured assets may turn out to be NPAs and hence the lower valuation. Analysts find it difficult to ascertain the level of NPAs on banks' balance sheets.
"In the case of Bank of Baroda , the price to book value is a mere 0.9 times 2012-13 earnings, as compared to the historical average of 1.15. Finally, the guidance from the management counts.
The management has indicated that there are no stressed accounts which will lead to higher restructuring in the coming year.
Multinational companies too are known to command low P/E ratios historically . Some analysts feel this is a good buying opportunity. Take the case of Aditya Birla Nuvo that has a low P/E of 9 (consolidated). The company has interest in a wide range of businesses such as fertilizer , textiles, carbon black, insulators , mutual fund, insurance and telecom. It has a 74% stake in Birla Sun Life Insurance and a 50% stake in the mutual fund business.
In both these businesses, the company is amongst the top five players in the industry. In the insurance business , for the first nine months of the year, the company doubled its earnings before tax from Rs 156 crore to Rs 344 crore.
In the telecom business, it has a 14% market share in the Indian market through Idea Cellular.
Some stocks trade at low P/E ratios on account of issues other than business fundamentals. There are issues relating to corporate governance or regulator clamping down heavily. Take the case of Educomp Solutions, where despite the company being in the high-growth education business, quotes at a P/E of only 7. The stock price has fallen from Rs 462 in May 2011 to Rs 133. "There have been concerns over the company's corporate governance standards, accounting practices, hence the lower valuations.
In the case of IRB Infra, the chairman of the company was asked by the CBI to undergo a lie detector test in connection with the murder of an RTI activist. This saw the stock slip from Rs 169 to Rs 115 in the last one month.
In the case of Manappuram Finance, RBI has put several restrictions on gold loan business. The stock which used to quote at Rs 60 and a P/E of 17 has fallen to Rs 20 and now trades at a P/E of 3. "Though the P/E ratio is low, due to restrictions from the RBI, one is not sure how the company will grow and hence investors would do well to stay away.