Share price equals future expectations

Vivek Kaul Wednesday, February 08, 2006 21:27 IST


Life can only be understood backwards; but it must be lived forwards — Soren Kierkegaard, Danish philosopher

MUMBAI: Kavi Kumar has two passions in life, reading books and listening to music. And to bankroll his twin passions he does a variety of odd jobs. One of them is teaching at the Sentinel Centre for Human Resources Development (SCHMRD). Over a period of time he had started firmly believing in the Socrates philosophy of teaching. He questioned his students thereby compelling them to think about a problem and come to a logical conclusion themselves.
“Pantaloon retail’s stock price on February 7, 2006, closed on Rs 1,699.95. If I add the earnings per share for the last four quarters it comes to Rs 24.61. Given this the trailing price to earnings (P/E) ratio for the company is 69. This is very high when compared with the P/E ratio of the Sensex, which on the same date was 18.64. Other listed retail companies seem to have a very high price to earnings ratio as well. Why is it like that?,” asked Kumar and set the ball rolling for a free wheeling discussion.
Price of a stock = future expectations,” came a voice from the back of the class. The back benchers were awake.
“Would anybody like to elaborate on that ?,” asked Kumar.
Anubhav Arora, the Mr Know-it-all of the class remembered reading something in a book titled Face Value written by Debashis Basu.
His fabulous memory allowed him to repeat that for the benefit of the class. “ A clearly visible, high growth future can change the valuation of the entire sector not just of one company. This was how the software companies started getting higher and higher multiples on the same incremental performance,” replied Arora.
“But were software companies highly valued from day one, Mr Arora?” asked Kumar.
“Initially the stock market was apprehensive. Software companies it was felt made their money through only body shopping and correcting the Y2K problem. It took the market sometime to realise that the Indian companies had successfully used these measures as an opportunity to get other business out of companies. Once the market realised this there was a re-rating of software companies and their stock prices started going up,” replied Arora. “And what happens if the stock market feels that the future is not clear?,” asked Kumar trying to take the discussion further.
“In that case even consistently good financial results do not lead to a higher stock price,” replied Varun Sinha, the fast thinker in the class. “Can you give an example to substantiate your point?,” asked Kumar.
“In a recent Wealth Creation Survey for the period 2000-05, carried out by Motilal Oswal, there were 30 state owned companies in the 100 - wealth creator group. Despite all the government controls, these state owned companies delivered 27% earnings growth during the study period. But at the end of the study period their average price to earnings ratio was 8.6. During the same period the private companies achieved an earnings growth of 34% but their average price to earnings ratio at the end of the study period was 14.3.
What this clearly tells us is that the stock market remains sceptical of the ability of the sustainability of the earnings of the state owned companies and hence has not rewarded them fully in terms of market capitalisation,” came a long wielding response from Sinha.
“All that’s fine. But it’s never too obvious as to what the future is. And doesn’t that lead to stock market bubbles, when a rosy picture of future is painted and then you have excess cash chasing a single investment theme?” asked Ashwini Kumar, suddenly waking up from a comfortable snooze.
Kumar felt he was trapped. Just as he was about to say something, the bell rang. “Thank God for small mercies,” he thought and walked out of the class.
The example is hypothetical