The one thing that really drives the share market value of your stock is the P/E ratio. Let us spend a moment to understand the role that the P/E ratio plays in market value of your stock. Unlike what a lot of 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 price. That is because 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 not only talking about the quantum of debt as measured by the leverage ratio but also by 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 is able to 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 cost 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 just to touch an EPS of Rs.1. Wealth creation was simply ruled out in the telecom industry. When the equity base is too large, as we saw in the case of many infrastructure companies and metal companies, the EPS comes under pressure and so P/E valuations are automatically low. To protect 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 not just consider the current capital base but also 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, 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 guidance for next few quarters and not just at 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 any 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 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 also the corporate governance issues that cropped after the original promoters gave up full-time management of the company. Corporate governance includes aligning the interests of the shareholders with the company, transparency levels and high standards of disclosure.
To cut a long story short, 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.