Buying Tata Motors shares at these levels could be a costly mistake

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PE ratio multiplied by the company's earnings per share (EPS). Although the formula is quite simple, a big mistake usually creeps in. I've seen even the best analysts fall prey to this error.

They constantly keep changing both the PE multiple as well as the EPS of a stock. I strongly believe that unless there is a huge structural change in the business, the PE multiple should be kept constant and only the EPS should be played around with. If you fiddle with the PE ratio too much, you end up assigning a higher PE multiple to a stock during good times and a lower PE multiple during bad times.

This leads to terrible investing decisions as it often makes an expensive stock look cheap and a cheap stock look expensive. In other words, your valuation is not objective – you are effectively dancing to the tune of the market. This is why I have always believed in keeping the PE multiple constant unless there are very strong reasons to change it.

Besides, I like to keep things simple even when assigning the PE multiple. I don't like paying more than 15-16 times earnings for an average business and more than 30-35x for a good one. I also like to be methodical when evaluating the true earning power of a company.

If there is plenty of fluctuation in earnings over the years, taking the average earnings of the past few years is a good idea. On the other hand, if the earnings have seen an upward trend, one may consider the latest EPS as a reflection of the true earnings power of the company. Let us understand this with the help of a couple of examples.

Shown above is the EPS trend of two companies for the past 10 years. Both are PSUs, gave good returns this year, are debt-free, and have solid business models. What should we consider as