The one thing that really 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 it is the input that determines the price. What does that mean? Assume two companies in the same industry with have the same EPS but different prices. The market is giving a higher P/E for the first stock, and a lower P/E is being assigned to the second stock. Why does that happen? There could be a variety of reasons. For example, earnings quality could be better or corporate governance could be better, or the financial risk may be lower. So any effort to protect the market value depends on protecting the P/E Ratio. There are 4 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, a popular ratio to measure the cost of debt is the interest coverage ratio. That shows how many times the EBIT can cover the interest cost. Higher the interest coverage, the better it is. Normally, you will find that companies with high levels of debt and high costs of debt will typically have greater financial risk and, therefore, 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 as to what is this equity vulnerability! 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. When the equity base is too large, as we saw in many infrastructure companies and metal companies, the EPS comes under pressure, 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 is dependent on how well you show growth in top-line and bottom-line. You must have seen how stocks like Reliance, 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 and not just current sales and earnings. Your guidance should tell a growth story, but it is more important to live up to your guidance. For example, TCS gets the highest valuations in the IT industry despite refusing to give forward-looking guidance., and Hindustan Unilever got re-rated the moment top-line growth kicked in.
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 the 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. In fact, Infosys today quotes at a P/E ratio which is 10X discount to that of TCS. Apart from the fall in margins, an important reason is the . But if the above four aspects are taken care of, then sharp value destruction can be avoided.