Dear Friends,

We have been discussing a lot about various techniques and key technicals in the financial market to gain our profits.

In general, when we select a stock for the investment purpose, the first thing we look at is the PE Ratio.

Then, we also examine the EPS.

Let's discuss on this in detail.

If the PE ratio is low while the company's ROE and EPS are high, you may think that the company is a highly profitable company!

But, the PE is so low—it seems like no one else has noticed it yet perfectly- I've hit the jackpot!"

If you choose a stock based on this line of thinking... Please stop right there!

Read this post in its entirety before making a decision on this.

In the stock market, the PE Ratio (Price-to-Earnings Ratio) and EPS (Earnings Per Share) are the two key metrics we all look at first to analyse and jude a stock's value.

The general rule is that a company with high profits is a good investment. However, one must not forget that the profit figures shown in a company's books can sometimes be an illusion designed to mislead investors also.

In the financial world, this phenomenon is known as Earnings_Distortion.

If you, as an investor, if you fail to understand this tactic, you might end up investing in the wrong company- thinking you’ve found a bargain—and lose your money. Just be careful.

Let us first understand what "Earnings Distortion" actually is!

Earnings distortion occurs when a temporary profit or loss, one not derived from the company's actual, day-to-day operations and gets included in its total profit figures.

As a result of this, the company's EPS and PE Ratio exactly do not reflect its true standing; instead, they may temporarily appear exceptionally good or exceptionally bad.

For example, just imagine a friend of yours runs a grocery store at your local place.

He earns a monthly profit of ₹50,000 from that store out of his routine business. This represents his regular business profit—or "Core Business Profit." Later, for a particular month, he earns an additional profit of ₹5,00,000 by selling an old delivery van from the shop.

The books of accounts for this month will show a total profit of ₹5,50,000.

If an outsider sees this and believes, "This grocery store earns a monthly profit of ₹5,50,000" and decides to buy the shop at a high price, they could end up disappointed.

This is because the grocer will not have the van to sell the following month, and the profit will drop back to ₹50,000.

The same scenario exactly plays out in the stock market.

There are three major reasons for such distortions in any company's profits: They are

1) One-Time / Extraordinary Gains:

A company may realise a massive profit when selling assets like land, buildings or shares in subsidiaries. This definitely causes profits to spike for that specific period (year/quarter), leading us to believe strongly upon seeing the financial statement—that the net profit is quite excellent.

2) Fair Value Accounting / Demerger:

When the market value of assets held by the company raises, it may be required to record this increase in its profit accounts (as notional or accounting profit). This also results in profits appearing in the millions on paper, even though no actual cash has been received in original.

3) One-Time Expenses:

Sometimes, companies incur huge fines or suffer losses from closing down a factory. This reflects as a massive loss for that specific quarter, but the company often returns to profitability in the subsequent quarter.

Let us also examine how such events can also mislead investors in a big way.

A common, major mistake we make in the stock market is buying stocks with a low P/E ratio, assuming they are "under-valued" (cheap). See how 'Earnings Distortion' can mislead you:

Due to some extraordinary circumstance, a company's earnings may temporarily surge manifold.

As profits rise, the Earnings Per Share (EPS) skyrockets.

When the EPS spikes suddenly like this, the PE Ratio drops to a very low figure (for instance, 1 or 2).

Seeing this, we might rush to invest, thinking, "Wow! The PE is only 5, yet the company's net profit is huge."

However, over the next few quarters, as that temporary profit vanishes and the EPS falls back to normal levels, the PE Ratio will naturally shoot up, and the stock price will plummet. This phenomenon is known as a "Value Trap." in the market.

How can you avoid this Value Trap?

When a stock shows impressive PE Ratio and ROE/ROCE figures, do not trust them blindly; instead, verify the following:

1) First, look for the Sales Growth. Just check is the company's sales (revenue) risen in tandem with its net profit? If profit has increased without a corresponding rise in sales, it indicates an 'earnings distortion.'

2) After this, check for the 'Other Income.' Look and explore for any significant amounts listed under 'Other Income' or 'Exceptional Items' in the Profit & Loss statement.

3) You must always compare the Operating Profit with Net Profit at all times.

You need to examine the profit generated from the core business (Operating Profit) Vs the profit remaining after accounting for taxes and other income sources.

Just explore and apply and have a great time in the markets!