(IM)purity of P/E Ratio

(IM)Purity of P/E Ratio

How do I decide which stock should I invest into? Well one such approach can be by finding out the P/E ratio of the companies that is available to all of us from the financial statement of the company in the annual report.

Now, what is this P/E ratio?

P/E ratio is the ratio of market price of the stock to the earning per share. Mathematically speaking, smaller is the P/E ratio better is the company to invest into. Smaller P/E means we are paying less for the share and earning more. For example IHCL currently has the P/E ratio of 21, this means that for every 21 Rupee spent the earning is Rs 1 as dividend per year (dividend is paid regularly where as the investment is one time). By this it looks that it’s all very easy to decide on, isn’t it? But I am afraid! it’s not as simple as its looks. Apart from the fact that P/E ratio in itself is not sufficient to tell you all about the company, thanks to the lax regulation, the companies can themselves temper with the facts and figures related to the presentation of company’s performance to give attractive P/E ratio.

This article is an effort to make you aware of some of such loopholes in Indian accounting principle in the simplest of language.

What the companies want?

Well, they want the value of the company to rise. They want to have very attractive P/E ratio. As they have little control over the price as it is decided by the demand and supply equation, what they try to do is to adjust the E of P/E ratio. Even to avoid the tax they can show their profit to be less by taking the advantage of lax regulation.

What are the areas where they can actually manipulate?

1. Depreciation : There is tax relief given to company on the depreciation of the fixed assets which is known as tax shield. Now depreciation is the year wise devaluation of assets like machinery, building etc which is charged on the PL account. Once it is shown in the PL account it reduces the profit. Now the question is how the companies uses the depreciation to project favorable P/E ratio. Actually there are two methods of calculation of depreciation i) Written Down Value(WDV) and ii) Straight Line Method(SLM). In WDV method the rate of depreciation is fixed at say 40% . So every year the value of assets is decreased by 40% of its value at the beginning of the month. But in SLM there is fixed amount charge every month irrespective of the value of assets present in the beginning of each year. For example let us say that a machine is worth Rs. 1,00,000 and the WDV method rate of depreciation is 40 % and its useful life is 5 years. So, by WDV the depreciation will be charged as :

Year	Original Value	Depreciation @ 40 %	New Value
1	100000	40000	60000
2	60000	24000	36000
3	36000	14400	21600
4	21600	8640	12960
5	12960	5184	7776

But in the case of SLM the every year depreciation is 1,00,000/5 = 20,000 (value of machine divided by the useful life ). Now different company uses different method and mere looking at the P/E ratio we can’t say which company has used which method. Also company are free to change there method to fir there requirement at its will.

2.Interest Capitalization:

Interest is that part of expense for a company that is paid to the debtors as a return for lending money. This interest charged is shown in the Profit and Loss account on the expense side (read debit side). Now if the loan is taken for an asset which is not yet installed then the interest payable, as per the accounting standard, can be added to the capital itself which is known as Interest Capitalization. This interest is actually an interest due and is a kind of expense and hence should be shown in the PL account instead. Also, many times the firm shows that the machine purchased has not been installed and avoid showing interest expenditure and thereby representing higher than actual Profit. Interest capitalization is now made mandatory from the year 1991.

3. Amortization Of Expenses :

There are various expenses incurred by companies well before the company is set up. This may include certain activities like administrative expenses incurred in signing of MOU etc. The expenses incurred are very huge and hence it is written-off (adjusted in the expenses part by part) in many years called Amortization. Accounting standard sets the time frame in which this expenses should be completely written-off the record but is quite on any particular method of writing-off. So, in the year of higher profit the company writes-off higher amount and the year of lower profit company will write-off lower amount there by having same profit even if the earning has been volatile. This way they manipulate profit and hence P/E ratio.

4. Research and Development Expenditure:

There are two types of R&D expenditure as per the Accounting standard 8 (AS-8). The Pure & Applied research and Development Research. The pure and applied research are those continuous research which are needed for the company to be competitive and survive. Development research are those research which is used for some innovation and completely new product launch. Now, as per the AS-8, the expenditure in the P&A research should be written-off in the same year where as that in the Development Research can be amortized (written-off in consequent years part by part). But company takes undue advantage some time as it is not clear as per the AS-8 that what research is P&A and what is Development research and the expenditures are being written-off in the same year or amortized depending upon the desired P/E ratio for the company.

5. Valuation Of Inventory:

There is always huge stock of inventory for all the companies like finished goods. Raw material and semi finished goods. These inventories are recorded under the Current asset heading of Asset side of balance sheet. The companies need to value it on LIFO(Last in first out) or FILO( first in last out). In case of change in inflation the company tend to shift from one to another to present the higher value of inventory. Suppose last year material cost was Rs 500 and this year the material cost is Rs 800. If one such good is

sold the company will report that the one which was at Rs 500 has been sold. If somehow the price has fallen down to Rs 400 then the company will say that the one with price Rs 400 has been sold. As the higher price of inventory will show higher profit the P/E ratio gets affected with the fact that what method of inventory valuation is being considered.

6. Treatment Of Gratuity : All the company have some amount for their employee to be paid to them when they retire known as gratuity. This can be recorded on the basis of accrual or cash. Now accrual basis is like earmarking a sum of money to be paid later on as and when the employee retires. In cash system it is recorded only when it is paid. One company may be using one method and another one may be using different one and hence their P/E ratio can’t reflect their correct comparison. Also, companies can at their will change their method. For example Indian Airlines showed a profit by bringing in money from gratuity fund provision when they actually made huge loss. They changed their method of recording from accrual basis to cash basis.

This way we can see that P/E ratio in itself can not be an indicator of the value of a stock. So next time when you see a company’s having very attractive P/E ratio think twice before investing into it. You may not be seeing the correct picture.

Related Articles:

The Sub Prime Issue!!!!!

Leveraged Buyout

Preferential Allotment

Private Equity in India