P/E never gives a direct buy or sell call

P/E never gives you a direct buy or sell call. The following cases are typical:

Case 1: The “E” in the P/E isn’t the real “E”. Due to extraordinary income, the net profit is up tremendously- which of course, we didn’t know since we did not check the results properly. For example, the company sold some land, or sold its entire business! It had income alright, but that income was one time income in the first case, and in the second case, the company had killed the goose laying the golden eggs. The stock has been driven up by speculators- just to the level of that 10 P/“E”. The same price would’ve been lower in case of the earlier E (minus the exceptional income) at the same P/E. You are not aware of this, and end up buying an expensive, or a junk stock. Then there are situations when profits have been eroded by extraordinary losses. So the current EPS doesn't show the real picture. When (next year/quarter) good results emerge, the P/E returns to normalcy.

Case 2: The “E” is okay, but the future is bleak. Suppose the company has a large pending order book. The company is doing well at the moment, executing its orders. But it is not receiving any new orders due to a general slump in the economy, or some other reasons related to the company or the industry. So the next years’ or quarters’ good sales, and therefore, earnings are not guaranteed. These are extremely risky stocks for medium term investors. Say you bought a share at 4 P/E @ Rs. 100, EPS (annualized) of Rs. 25. Next quarter results disappoint the market. The order book is empty; the company manages an EPS of Rs. 2. The stock crashes, and you lose money. Moral of the story? Check the P/E of the peers of the company. If they’re low at the same time, may be some government policy decisions or some industry related slump or some other bad news are affecting the stock. Avoid for the medium term. Classic examples are the shipbuilding stocks at the moment.

Case 3: There would be new companies; there would be companies in the expansion mode, doing M&A, and breaking new ground. When good news surrounds a company, its stock price moves up, and consequently the P/E goes up. Growth expectations are high, and so price is high. Classic case of Power stocks (high P/E) vs Bank stocks (low P/E). It isn’t an expensive stock if the consecutive earnings are going to catch up with the high P/E. But one has to exercise caution, and filter the correct news from the speculation.

Case 4: Refineries. Movements in crude oil prices affect refining margins. This affects the net profit, and therefore, the “E” in the P/E. Say oil prices zoom, refineries post great results. EPS rises for consecutive quarters. The price also rises in tandem, and slowly outruns the EPS rise. You buy, since it’s still low P/E courtesy the killing the refineries made in the last quarters. Then crude oil price crashes. Suddenly, for the quarter, the stock price stagnates. You buy more, unaware of the crude oil price movements. The results come out, and the refinery has posted a loss. The “E” has vanished, and so has your money. Know what business your company is into, thoroughly.

Case 5: Different sectors & diversified businesses. One should never compare P/Es of different companies in different sectors, or of companies in diversified companies. Again, you should know what business the company is into. Always compare across peers.

Case 6: Exceptions and unnoticed shares. There are some golden chests lying around, which no one has opened, simply because no one knows they’re there. If you’re lucky enough to find such stocks, and you’re ready to hold them till everyone notices, you’ve probably made The Killing. Such stocks are rare, and generally have low P/E. You’ve got to comprehend the P/E, perform a thorough analysis of available data and then take a decision. And of course, you’ve got to give it time.