Making sense of P/E ratio – Plotting P/BV with ROE
We have learnt about the price to earnings ratio in our Financial Analysis class and based on it we have often gotten into debates regarding the undervaluation or overvaluation of the subject companies with our colleagues. We are guided by our professors, textbooks etc. that one cannot look at the price to earnings ratio in isolation and reach to any particular conclusion from it.
To address this limitation the model we are going to discuss here is going to use two inputs P/BV and ROE.
Price to earnings ratio = Current market price / Earnings per share
EPS actually is return to the equity shareholders on the book value invested in the business.
Return to equity shareholders = Book value (total net worth) * Return on Equity (ROE)
Using the above two equations the formula for price to earnings ratio can re-written as –
Price to earnings ratio = (Current Market price/ Book value per share)/Return on equity
P/E ratio has been dissected into these two components because analysis of these two factors historically has shown that the P/BV multiple very closely tracks the changes in the returns on equity. (Analysis shown below)
I took the Price to book value ratio and return on equity (%) of 50 companies forming the NIFTY index and plotted these values on a scatter plot and then generated the best fit line from the coordinates. With a little eye balling we can conclude that most of the coordinates lie close to the best fit line displaying that market is pricing most of the NIFTY 50 companies in line with their Return on Equity (%). Also we can see a strong R-square of 0.736.
From the above, intuitively we can conclude that the coordinates lying above the best fit line show the stocks which are valued above what markets actually generally expect and vice versa for points lying below the best fit line. And higher the distance of coordinates from the best fit line higher will be the extent of over/under valuation.
Despite low ROE, market may value a particular stock at higher multiples as compared to the market in general because of reasons like high expected future growth and contrary to this higher ROE need not necessarily lead to a higher price to book value ratio because of risks associated with the business/company.
The above analysis can be done for different indices, sectors etc. depending on the requirement.
Analysying and Valuing Fixed Income securities
Analysis of RECL Tax – Free bonds
The effective interest rate analysis of the bond is as follows:
| Income slab | Income tax slab | Effective Coupon |
| 2 – 5 lacs | 10% | 8.578% |
| 5 – 10 lacs | 20% | 9.650% |
| Above 10 lacs | 30% | 11.029% |
Across all public as well as private sector banks the maximum annualised return offered on Fixed Deposits is 8.77% p.a.
And PPF offers a tax free return of 8.8% to its subscribers. So return on these bonds can be considered as pretty much competitive in comparison to the available fixed income option for retail investors.
NOTE: Although interest on application money (if refunded) is only 5% but it is not a matter of concern as investors can apply in the issue using ASBA facility.
Investors may not find this offering that attractive just by looking at the return offered by way of interest income only. The other factor which should be considered is making a profit by selling the security in secondary market. As per the term sheet the bonds will be listed on both BSE and NSE and have no lock in period.
Valuation of 10 year bond (using DCF method) @ (10 year reference rate of GOI security + applicable spread for relevant tenor on AAA rated security)
10 yr reference rate of G-sec: 8.36% p.a.
Credit spread applicable on 10 yr AAA rated bond: 66 bps
Hence, benchmark yield (Reference rate + Credit spread) = 9.02%
| Bond | 7.72% RECL 2022 10 year Tax free |
| Duration | 10 |
| Periodicity | 1 |
| Allotment Date (Assumed) | 15-Dec-12 |
| Maturity Date | 14-Dec-22 |
| Referance rate | 8.84% |
| Coupon for calculating trading profit | 7.22% |
Valuation:
| Income slab | Income tax slab | Effective Coupon | Effective Coupon for calculating trading profit | Valuation @ Benchmark yield |
| 2 – 5 lacs | 10% | 8.578% | 8.022% | 93.60 |
| 5 – 10 lacs | 20% | 9.650% | 9.025% | 100.03 |
| Above 10 lacs | 30% | 11.029% | 10.314% | 108.30 |
Note: For the above valuation the coupon has been considered as 7.22% rather than 7.72% p.a. because as stated in the offer documents the coupon of 7.72% is only offered to primary retail investors. For all the investments made through secondary market the coupon will be 7.22% p.a.
Scenario analysis of various possible benchmark yields –
| Benchmark yield | |||||||||
| Tax Bracket | 8.90% | 8.93% | 8.96% | 8.99% | 9.02% | 9.05% | 9.08% | 9.11% | 9.14% |
| 10% | 94.34 | 94.16 | 93.97 | 93.79 | 93.60 | 93.42 | 93.24 | 93.05 | 92.87 |
| 20% | 100.80 | 100.61 | 100.42 | 100.22 | 100.03 | 99.84 | 99.65 | 99.46 | 99.27 |
| 30% | 109.11 | 108.91 | 108.70 | 108.50 | 108.30 | 108.09 | 107.89 | 107.69 | 107.49 |
From the above analysis it can be construed that investors have significant opportunity of making trading gains by applying in the public issue.
As with all trading calls, there are few concerns associated with these trading call too. These are enumerated below:
1. November inflation data is still awaited and will be released on 12 December 2012, if there is a rise in inflation rate in November over October 12 there can be increase in yield on 10 year GOI security which will in turn result in increase in benchmark yield thereby bringing down the valuations. October inflation figures saw a downtrend and WPI was seen at a 10 month low.
2. Rising fiscal deficit is also pushing inflationary expectations up. Here is the excerpt from a statement made by RBI deputy governor Subir Gokarna on 03 Dec 12 –
"Fiscal deficit is somewhere in the region of 5.5 per cent or so. The government estimates that it will bring it to 5.3 per cent, but quite some distance from the 2.5 per cent- benchmark achieved in 2008,"
"That’s creating some stresses from the inflationary point as well as from the point of resources going into finance government consumption,"
3. Mid quarter review on monetary policy is also due on 18th December 12 and it is yet not clear that whether RBI will go for the rate cut or not. In case of rate cut yield on 10 year GOI security will ease and will result in increased valuations for this bond. Other way round is also possible.
On an overall basis the bond seems to be a good option for investments by retail investors. And pro rata allotment can be expected if application is made as oversubscription will be there.
| Connect with Kotak on |  |
 |
 |
 |
 |
DISCLAIMER:
This communication is confidential and privileged and is directed to and for the use of the addressee only. The recipient if not the addressee should not use this message if erroneously received, and access and use of this e-mail in any manner by anyone other than the addressee is unauthorized. If you are not the intended recipient, please notify the sender by return email and immediately destroy all copies of this message and any attachments and delete it from your computer system permanently. The recipient acknowledges that Kotak Mahindra Bank Limited may be unable to exercise control or ensure or guarantee the integrity of the text of the email message and the text is not warranted as to completeness and accuracy. Before opening and accessing the attachment, if any, please check and scan for virus.
ICAI releases Case laws relevant for November, 2011 CA Examinations
TO Download the file click on following links :
Download the ammendments applicable for NOV 11 Attempt of CA Exams (FINAL and IPCC)
List of Institute’s Publications relevant for November 2011 examination
Download the list of Institute’s Publications relevant for November 2011 examination :- Click Here
Required Qualified Chartered Accountant in INDORE
One of the biggest Corporate in Indore requires qualified Chartered accountants with more than 2 years experience in managerial audit,Package no bar .
Candidates basically from Indore will be preferable.
Interested candidate can mail their resume to hdporwal@gmail.com
RBI MASTER CIRCULAR ON ASSET CLASSIFICATION AND PROVISIONING
Case laws relevant for May, 2011 and November, 2011 examinations
For Downloading Case laws for DT click on following link:-
For Downloading Case laws for IDT click on following link:-
List of all topics relevant for MAY 11 Attempt of CA Final, IPCC/PCC issued by ICAI
To Download Click on following link :-
List_of_institute_s_publications_relevant_for_may_2011_examination
Board of Studies Announcement for Changes in course from old to new syllabus
To download the complete list Click on the following link :-
Join CA_Update SMS Channel
Join it now!
CACTUS 