The P/E ratio is a function of how much an investor will pay for every rupee earned by the company. For example, if a company’s CMP is Rs. 200, and it earns Rs. 100 cr in net profit with 10 cr shares outstanding. Then the EPS would be Rs. 10. The P/E ratio would be 20x implying that investors are willing to pay Rs. 20 for every rupee earned by the company. Now let us understand Why does P/E ratio differ across sectors?
Firstly, there is the general market P/E ratio which is derived by calculating the P/E ratio of key benchmark indices (Nifty and Sensex). Over the years, we have seen that the P/E ratio (v/s historical average) for Indian markets has expanded, implying that India has become one of the most preferred destinations for investments. And rightly so, as India is one of the fastest growing major economies, inflation remains well under control, fiscal prudence is maintained and we have a stable government. Hence, over the years, we have seen a general expansion in P/E ratios of stocks. In contrast, the general market could also contract in the event of a global recession and/or a reversal in the above factors.
Then there are sector-specific P/E ratios that differ across sectors. Now, why is that? It is mainly because certain sectors are highly sensitive to external factors that are not under the company’s control like commodity prices, interest rates, etc. Hence, we see cyclical sectors like Autos, Metals, Oil & Gas generally have lower P/E ratios compared to other defensive sectors like FMCG and Healthcare that enjoy higher ratio as they are less sensitive to external factors.
There could be some other sector-specific growth drivers/concerns that can lead to expansion/contraction of P/E ratios. For example, GST implementation led to P/E expansion in many sectors (Tiles, Plywood, Electricals, etc.) as the shift from unorganized to organized was expected to be faster than expected. However, slower than expected transition led to a sharp correction in many of the stocks in the sector. Healthcare is one of the defensive sectors that witnessed a contraction in P/E ratios because of regulatory concerns and pricing issues in the US. Hence, any sector-specific growth driver/concern could lead to expansion/contraction of the sector average PE.
Then we come to company-specific risk, which affects P/E ratio of companies. For example, P/E expansion could take place if a company has been consistently gaining market share and/or performing better than industry growth. The perfect stock for the above condition would be Maruti. On the flip side, concerns related to only a specific company could lead to PE contraction. Further, better operational efficiencies, low debt levels, better cash flow generation, and sound management compared to peers could also lead to PE expansion and vice versa.
To put things in perspective, one must look at historical average P/E (5-Years or 10-Years) of the stock and take into consideration the three parameters mentioned above and then take a decision accordingly on whether the current P/E is justified for the stock.
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