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PE ratio ineffective for 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 evaluate the relative value of a stock or an index—is an ineffective valuation methodology for several sectors and stocks in India where earnings do not meaningfully translate into FCF (free cash flow) or returns to shareholders. Kotak believes many low PE sectors and stocks may not be as cheap as their headline numbers suggest. "We revisit the futility of PE valuations for valuing several sectors and stocks in India, given (1) low FCF-to-PAT in such sectors, (2) continued investment for incremental volumes and (3) continued investment in low-return businesses," said Kotak in a note on May 28.

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 can be an ineffective way to assess the valuation of certain companies, particularly in sectors where earnings do not accurately reflect the company's financial health or ability to generate cash. Free cash flow (FCF) measures how much cash a company generates after accounting for capital expenditures.

Kotak believes that the PE ratio is not useful for valuing companies in several sectors, such as automobile, tyres, cement, and speciality chemicals, and the type of companies, such as state-owned oil, gas, and fuel providers as in these sectors earnings don't effectively translate into free cash flow (FCF) or dividends.

"The market’s focus on PE (high or low is less relevant) is misplaced for such sectors, without taking cognisance of conversion of PAT to FCF," said Kotak. Giving the cement sector as an example, Kotak underscored that cement companies will continue to have high capex to deliver incremental volumes in the future. This will result in their FCF trailing PAT due to their low fixed asset turnover ratio.

"Cement companies had low FCF relative to their PAT, which will likely persist. We see strong volume growth, driven by housing and infrastructure demand, but the industry must incur large capex to support the growth. The debate around profitability is less relevant," said Kotak.

Similarly, Kotak said the oil, gas, and consumable companies, especially PSUs, will continue to invest in their core businesses, resulting in very low FCF relative to PAT.

Kotak pointed out that specialty chemicals companies have ambitious plans, requiring large capex, which results in low FCF in the medium term. They have historically seen low FCF/PAT ratios. "The current high PE valuations of the sector are underpinned by expectations of strong FCF generation in the future, which may or may not materialise once the growth phase is overdue to (1) the contractual nature of the business and (2) increased competition over time," said the brokerage firm. While PE may not be an effective method of valuing high-growth companies, state-owned firms, and capital-intensive sectors, experts say other valuation metrics, such as enterprise value to EBITDA (EV/EBITDA) and return on equity (RoE), might provide a more comprehensive and accurate assessment of a company's financial performance and potential.

RoE shows how well a company is using the money invested by its shareholders to generate profits. EV/EBITDA provides insight into a company's operating performance and shows whether it is fairly valued, overvalued, or undervalued compared to its peers.