Valuation guru trashes P/E ratio & correlation; says they rarely work

Even the average stock investor understands PE, or price-to-earnings, ratio. So when an analyst says the PE ratio is too high, most investors interpret it as a signal to sell that stock.

By definition, the PE ratio tells you the price an investor is willing to pay for per rupee earning in a stock. Thus it is considered a gauge of investor’s bullishness or bearishness on a counter.

But valuation guru Aswath Damodaran disagrees. The professor of finance at the Stern School of Business at New York University says PE as a measure of stock valuation seldom works.

Damodaran is best known as author of several widely-used academic and practitioner texts on valuation, corporate finance and investment management. He is also known as being a resource on valuation and analysis to investment banks on Wall Street.

“Market indicators such as price-to-earnings (P/E) ratio, correlation and regression do not always work,” Damodaran said in an interview with ETNow.

“Give me an investment strategy that I can build using these indicators and I can test it for you and let’s see if it works. I have not found these market indicators working as an investment strategy,” Damodaran said.

Correlation is a measure of a mutual relationship or connection between two variables, in this case of a stock with the benchmark index, say. Regression, on the other hand, measures the relation between the mean value of one variable and corresponding values of other variables.

Damodaran believes things are changing rather slowly in developed markets compared with that in emerging markets.

He said US markets, which are hovering around their all-time high levels, will continue to consolidate for some time.

In the Indian context, Damodaran loves Eicher Motor’s Royal Enfield story. He said Royal Enfield has been able to adapt and change its story and expand into a global brand. However, he believes the stock is looking expensive at its current market price.

On the banking side, he prefers ICICI Bank to HDFC Bank. HDFC Bank on Tuesday surpassed Reliance Industries to become the country’s second most valued firm in terms of market capitalisation.

On the performance of Maruti Suzuki, Damodaran said, “I do not think any other automobile company can sell their cars at prices that Maruti is selling their cars now and still make money. Until that changes, Maruti will continue to gain the benefits of cost advantage.”

On Wednesday, Maruti Suzuki shares were trading above Rs 7,300 on BSE.

Damodaran says the golden days of Indian IT firms are over and they would not be able to relive their past glories again, as other people have managed lower costs than India and the cost advantage game has ceased to exist for Indian IT.

“Secondly, increasingly automation is replacing people. The biggest advantage that TCS and Infosys had was cheaper people, but if 95 per cent of your costs are machines, there is no advantage anymore. So the underlying basis for those business models has faded,” he said.