About PE ratios and the right time to buy

I was asked an important question by Raghu, and I thought I'd blog it for everybody else also

Raghu said...
Hi Naveen.Today I read in TOI that the Sensex may breach 11000 levels which means there is still lot of downside left.In such scenario do you think it is a good time to open the positions? I am not talking about value stocks like JKL but some good stocks which have taken the beating along with junk stocks. Though I understand that an optimum PE Ratio for each co varied based on its future prospects can you pls advice as to is there any standard/PE for evaluating Small/ Medium and large scale firms respectively.Also I have noticed that after a bear phase market gives an excellent returns for the following next 2 -3 years. Is it true or just a co-incident. Just a curiosity question pls.

Hi Raghu, it is the nature of the market that the participants get overly optimistic when the times are good and overly pessimistic when the times are bad. There are excesses on the way up and also on the way down. A good player will choose his/her target company carefully and should be able to evaluate it both in relation to and independent of the Indices.

You've asked me what is the optimum PE ratio for various groups of companies. There is no standard PE ratio which will fit every stock. It will vary from industry to industry and from stock to stock. Take for example, a stock like Punj Lloyd. I gave a sell on that stock when it was trading around 500-550 levels. At the same time many so called 'Analysts' (the ones who regularly appear on certain TV channels) were singing praises of that stock and advising a buy. The stock today closed at 297. Most people would think it is a great opportunity to buy that stock because it has fallen 45% from its highs. But do you know what PE it is trading at even now for FY08? 27!! That means that it was trading at a PE of 50 when the price was at 550. Compare that with the the current PE of JK Lakshmi which is less than 2.5.

How would you reconcile this anomaly? The truth is that the market does not always run on fundamentals. In fact, it seldom runs on fundamentals. More often than not, it runs purely on the will of the Operators and the Hype generated about that stock. But this is true only in the short to medium term. This is so because the vested interest parties cannot keep the price of a stock up or down as per their convenience beyond the medium term. In the long term the true fundamentals of a stock have to catch up. Punj Lloyd is just an example I am giving to elaborate my point. If you look closely, you will find that Punj Lloyd is still Up nearly a 100% from its year's low of 147 which was the prevailing price in April, 2007. But public memory is short, so they don't remember the figure of 147 attached with Punj Lloyd, they only remember the recent high price of 550. If you ask me, then the fair value of this stock should be between 150 and 175....................maximum 200. But the 'TV Analysts' would have you believe that it is a great buy even at 550!

At the peak of the recent Bull market, certain Power stocks were trading at PEs between 70 and 100. Thankfully, today many of them have come down to nearly half that. Though there is no thumb rule as to what should be the Optimum PE limit for any stock, I personally would be very uncomfortable in buying any stock over a PE of 25, no matter how good the company or the management, in the present scenario.

Coming to the last part of your question.........ofcourse bear markets give an excellent opportunity to buy good stocks at throwaway prices, but provided you buy the right stocks and for the long term. The simple basic rule of the market is to buy low and sell high. But it is ironical that most people actually end up doing the opposite.
Cheers!