The one thing that drives the share market value of your stock is the P/E ratio. Let us spend a moment understanding the role that the P/E ratio plays in the market value of your stock. Unlike what many investors believe, P/E is not the outcome of price and earnings, but the input determines the price. What does that mean? Assume two companies in the same industry have the same EPS but different prices. The market gives a higher P/E for the first stock, and a lower P/E is assigned to the second stock. Why does that happen? There could be a variety of reasons. For example, earnings quality could be better, corporate governance could be better, or the financial risk may be lower. So, any effort to protect the market value depends on preserving the P/E Ratio. There are four ways to go about it.
1. Reduce debt vulnerabilities
When we talk of debt vulnerabilities, we are talking about the quantum of debt as measured by the leverage ratio and the cost of debt. For example, the interest coverage ratio is a popular ratio for calculating the cost of debt. That shows how many times the EBIT can cover the interest cost. The higher the interest coverage, the better it is. Normally, you will find that companies with high debt levels and high debt costs typically have greater financial risk and command lower P/E ratios. Debt is normally a trade-off between higher ROE and higher insolvency risk.
2. Reduce equity vulnerabilities
You may wonder what this equity vulnerability is! Let us go back to the example of Tata Tele. With an equity base of 500 crore shares, the company needed to earn Rs.500 crore each year to touch an EPS of Rs.1. Wealth creation was ruled out in the telecom industry. The EPS comes under pressure when the equity base is too large, as we saw in many infrastructure and metal companies, so P/E valuations are automatically low. To protect the market value and protect the P/E ratio, the key is to keep your equity base as low as possible. Also, market P/E will consider the current capital base and potential dilutions like warrants, ADRs, GDRs, etc.
3. Focus on growth and be conservative on guidance
Your P/E depends on how well you show top-line and bottom-line growth. You must have seen how stocks like Reliance, Britannia, and Hindustan Unilever got re-rated the moment top-line growth kicked in. Markets always pay a premium for growth in the top line and then for the net profit margins. Above all, markets look at the guidance for the next few quarters, not just current sales and earnings. Your guidance should tell a growth story, but living up to your guidance is more important. For example, TCS gets the highest valuations in the IT industry despite refusing to give forward-looking guidance.
4. Focus on corporate governance issues
In the last few weeks, you must have seen stocks like PC Jewellers, Vakrangee, and Manpasand Beverages crack sharply in light of serious corporate governance lapses. Even if you have put the first three aspects in place, you will still be required to maintain high standards of corporate governance to ensure that the market P/E ratio is sustained. Infosys today quotes at a P/E ratio, which is a 10X discount to TCS’s. Apart from the fall in margins, an important reason is the you do not have control over your stock price. But if the above four aspects are taken care of, then sharp value destruction can be avoided.
