The term price multiple refers to a ratio that compares the share price with some of monetary flow or value to allow evaluation of the relative worth of a company’s stock. Some practitioners use price ratios as screening mechanism. If the ratios fall below a specified value, the shares are indentified for purchase, and if the ratio exceeds a specified value, the shares are identified as candidates for sale.
The P/E ratio expresses the relationship between the price per share and the amount of earnings attributable to a single share. In other words, the P/E ratio tells us how much as investor in common stock pays per rupee of earnings.
The broader market indices have fallen in the recent past, but the commonly used valuation ratios, such as the price-to-earnings ratio (PE), didn’t mirror this fall. This is because earnings per share (EPS), the denominator in this ratio, also came down during this period, thus not allowing any fall in the share prices to be reflected in the PE ratio. This is where cyclically adjusted PE ratio (CAPE) or Shiller PE becomes useful.
The Shiller PE ratio has been developed by Robert Shiller of Yale University, winner of the Nobel Prize for Economics in 2013. The main advantage of the Shiller PE ratio is that it eliminates the fluctuations in the regular PE ratio caused by variations in profit margins during business cycles. The regular PE uses the trailing 12 months earnings per share (EPS). Since companies usually report high margins and earnings during up cycles, the regular PE will be low during cyclical peaks, sending out buy signals. Similarly, during margins and earnings crash during cyclical bottoms, the regular PE will be high, and give out sell signals. For example, the share price of Cairn India almost halved in the recent past, but its PE doubled because of the fall in EPS. You can also see a similar situation with stocks of public sector banks such as PNB.
WHY TRADITIONAL PE CAN BE MISLEADING?
Even though stock prices have fallen for the year, their PE has spiked. However, Shiller PE, has risen moderately.16-Mar-1516-Mar-16CompanyPricePE/SPEPricePE/SPEFall in Price (%)Gain in PE/SPE (%)Cairn (I)2185.27 / 4.30148.321.89 / 4.79-31.97313.85 / 11.23Hindalco Industries126.825.82 / 2.6381.540.95 / 2.85-35.7358.6 / 8.45ACC1587.5525.66 / 17.021236.1539.49 / 17.89-22.1353.9 / 5.10GAIL (India)381.5513.82 / 9.94339.721.13 / 10.41-10.9752.89 / 4.78Ambuja Cements256.6526.57 / 16.56206.239.65 / 17.44-19.66
49.23 / 5.31
Cape Ratio also has some limitations to the measure. The ratio relies on historic 10-year data while many analysts prefer to find value based on future earnings prospects of a company. Also, while it considers a long 10- year cycle the average EPS used may get impacted by a one-off major event.