On June 13, the price of a single share of MRF hit the Rs 1-lakh mark during the day, the first share in Indian stock market history to do so.
But that of its competitor Apollo Tyres Ltd is priced at only Rs 408. That is, MRF's share price is around 245 times that of Apollo’s. A radial tyre for a small car manufactured by either of these companies is available at around Rs 3,000, give or take a couple of hundred. This means the products manufactured by either of these companies are available at more or less the same price. Also, since both companies operate in the Indian market their costs of manufacturing that tyre are also likely to be similar.
So why buy an MRF share at around Rs 1 lakh when Apollo Tyres is available at a discount of around 99.6%? Many novice retail investors reason along these lines and buy stocks with low nominal prices just as they would pick a low-priced item from a supermarket rack. But is this right?
To find out, let us take an example. Imagine there are two bakeries in a town - Delicious Bakes and Tasty Bakes. Delicious Bakes sells a piece of Black Forest cake at Rs 300 while Tasty Bakes sells a piece of Black Forest cake of the very same quality at Rs 160. Still, out of the 100 kg of cakes sold every day in that town, 60 kg is sold by Delicious Bakes while Tasty Bakes sells only 40 kg. Shouldn’t everyone buy from Tasty Bakes? No. Because a piece of cake sold by Delicious Bakes is 200 gm whereas the piece of cake sold by Tasty Bakes is 100 gm. To be more precise, the cost per gram of Delicious Bakes is Rs 1.5 per gm while it is Rs 1.6 per gm in the case of Tasty Bakes. That is, even though both the bakers offer a single piece of cake each of similar quality, they are dissimilar in size and weight; hence dissimilar in price too.
Similarly, one equity share of MRF is not similar to one equity share of Apollo Tyres. If it was cost per gram in the above example, what is it in the case of equity shares? The answer is book value per share and net profit per share.
To understand, let us take one more example. Imagine two different car manufacturers, A & B who set up a new plant each and both identical in all respects. Both the manufacturing facilities cost Rs 10,000 crore each. Both of them funded half the cost of the plant with a bank loan of Rs 5,000 crore and the remaining from shareholders’ capital. Think of this Rs 5,000 crore capital as a lump of cheese - it can be sliced thin or thick. Company A slices this capital thick into 50 crore shares and prices each share at Rs 100 to raise Rs 5,000 crore while company B slices the capital thinner into 500 cr shares with each share priced at Rs 10.
Thus both A & B have a car manufacturing plant valued at Rs 10,000 crore each. Half the claim on each plant is with the bank which has lent Rs 5,000 crore and the claim on the remaining half, called net assets or net worth, is with the shareholders. But how much claim does one share have? It is the value of net assets divided by the number of shares issued, called book value per share, one share of company A, which is “thicker”, has a claim of Rs 100 (Rs 5,000 cr/50 cr) while that of the “thinner” share of company B is Rs 10 (Rs 5,000 cr/500 cr). Obviously, then, the thicker slice will trade at a much higher price than the thinner slice.
If both the companies earned a net profit of Rs 1,000 crore in a year, the net profit per share (called earnings per share or EPS) will be Rs 20 for A (Rs 1,000/50) and Rs 2 for B (Rs 1,000/500). So will these companies’ shares trade at the same price? Certainly not as A’s EPS is 10 times that of B.
Thus to compare the prices of two shares, the metrics used are the ratio of market price per share to book value per share (price to book ratio or PB ratio) along with market price per share to net profit per share (price to earnings ratio or PE ratio/multiple).
So how does MRF stack up against Apollo Tyres on PB and PE basis?
PB and PE of MRF are 3.02 and 55.15, respectively, while it is 2.20 and 23.46 for Apollo. Thus an MRF share is priced 1.37 times (3.02/2.20) that of an Apollo on a PB basis and 2.35 times (55.15/23.46) on a PE basis. Hence on these counts, MRF is expensive compared to Apollo Tyres, but way below the absurd looking 245 times on a nominal share price basis. And even when you compare two companies in different sectors, say an MRF with an Adani Enterprises, these ratios can be used. Thus MRF at a PB ratio of 3.02 is cheaper than Adani Enterprises at 10.78.
So is investing in shares simply an exercise of mechanically measuring these ratios and then deciding which of the shares is cheaper? From a football match scoreline of 1 – 1, will one conclude that both teams played equally well? Of course not, as not everything is captured in the scoreline. Similarly, the calibre of management and board of directors, the standard of corporate governance, the future of the industry the company belongs to, the regulatory environment, etc are not captured in these ratios.
Moreover, book values and earnings per share reflect the past whereas share prices discount the future, and the future may not always be a repetition of the past. Thus winners of today need not necessarily be winners of tomorrow. To sum up, share price ratios are the skeleton on which the rest of the financial analysis should be built.
(An ex-banker, Ranjit currently teaches economics and finance)
