PE ratio ineffective in valuing certain sectors and stocks in India: Kotak Securities

According to brokerage firm Kotak Securities, the PE multiple (price to earnings multiple) – a key valuation metric used by investors to assess the relative value of a stock or index – is an ineffective valuation methodology for several sectors and stocks in India where earnings do not translate significantly into FCF ( free cash flow) or returns to shareholders.

Kotak believes that many low-PE sectors and stocks may not be as cheap as their headlines suggest.

“We reconsider the futility of PE valuations in valuing several sectors and stocks in India, given (1) the low FCF to PAT ratio in such sectors, (2) continued investment in ever-increasing volumes, and (3) continued investment in ventures with a low rate of return,” Kotak said in a May 28 note.

The PE ratio is a simple way to measure how expensive or cheap a company’s stock is compared to its earnings. However, the PE ratio may be an ineffective way to assess the valuation of some companies, particularly in sectors where earnings do not accurately reflect a company’s financial health or ability to generate cash.

Free cash flow (FCF) measures how much cash a company generates after capital expenditures are taken into account.

Kotak believes that the PE ratio is not useful for valuing companies in several sectors, e.g. automotive, tires, cement and specialty chemicals, nor for the type of companies, e.g. state-owned oil, gas and fuel suppliers, as in these sectors profits are not effectively translate into free cash flow (FCF) or dividends.

“Market focus on PE (high or low is less important) is inappropriate for such sectors without considering PAT to FCF conversion,” Kotak said.

Citing the cement sector as an example, Kotak emphasized that cement companies will continue to have high capital expenditure to deliver increasing volumes in the future. This will reduce their FCF relative to PAT due to low fixed asset turnover ratio.

“Cement companies have had low FCF relative to their PAT and this is likely to continue. We see strong volume growth driven by demand for housing and infrastructure, but the industry needs to make large capital expenditures to support growth. The profitability debate is less important.” Kotak said.

Similarly, Kotak said oil, gas and consumables businesses, especially PSUs, will continue to invest in their core businesses, which will lead to very low FCF compared to PAT.

Kotak pointed out that companies from the specialty chemicals industry have ambitious plans that require large investment outlays, which results in low FCF in the medium term. They have historically had low FCF/PAT ratios.

“The sector’s current high PE valuations are based on expectations for strong future FCF generation, which may or may not occur beyond the growth phase due to (1) the contractual nature of the business and (2) increased competition in the stock market,” she said brokerage company.

While PE may not be an effective method for valuing high-growth companies, state-owned enterprises and capital-intensive sectors, experts say other valuation metrics, such as enterprise value to EBITDA (EV/EBITDA) and return on equity (RoE), can provide a more comprehensive and accurate assessment of the company’s financial performance and potential.

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