Have you ever experienced the following scenario: you buy 1 kg of apples at Rs 100 per kg, only to find out they were available at Rs 80 per kg just a few feet away? Aren’t you disappointed at having to pay more for the same quality of apples?

The same also applies to stocks.

If you buy a share of company ‘A’ for Rs 100 and later on find out that the share of company ‘B’, with better earnings prospects, is available for Rs 60, it is bound to disappoint you.

So how do you find quality bargains? How can you decide if the current stock prices make sense? Does the price justify the earning prospects of the company?

The answer to these questions is Price-Earning (PE) ratio.

Introduction to PE ratio: PE ratio is one of the most widely used tools for stock selection. It is calculated by dividing the current market price of the stock by its earnings per share (EPS). It shows the sum of money you are ready to pay for each rupee worth of the earnings of the company.

PE = Market price / EPS

Interpretation of PE ratio is heavily dependent on comparison of the company with its peers. Also, PE that is considered very high in certain sectors can be considered very low in other sectors.

It is advisable to study the P/E ratio in concurrence with other profit indicators to get a wholesome picture of a company’s performance.

Interpreting the P/E Ratio

One simple way to understand P/E is that it gives the number of years the company will need to generate enough value to cover the cost the stock at the current market price (assuming no growth in earnings).

Like any business, the value of a stock is directly related to the company’s ability to generate cash. Thus, in a sense, a lower price-earnings ratio often suggests value.

The P/E ratio also reflects the market’s expectations regarding the future performance of the stock. A higher price-earnings ratio indicates higher expectations for the company.

Using the P/E ratio, we can compare the relative earning power of the companies regardless of their size or stock price.
On the surface, a $50 stock may seem more expensive than a $20 stock but if the $50 stock earns $5 a share while the $20 stock earns only $1, using the P/E ratio, you will be able to see that the $20 stock is twice as expensive as the $50 stock.

What is a good P/E ratio?
There may be no such thing as a good price-to-earnings ratio. When P/E is high, one can either say it’s too expensive or argue that growth prospects are good. On the other hand, when P/E is low, one can say that it is undervalued or that the company’s future is not too bright.
Moreover, even the average P/E varies across companies in different industries.

Conclusion
The P/E ratio is just one of the many financial ratios that are used to evaluate stocks. As it is an often quoted metric, it seems like an all-important ratio to many investors but in reality, it is definitely inadequate to base your investment decision on just this metric alone.

A high P/E ratio may indicate a share is overpriced, in which case you may decide to sell it on the expectation that its inflated price will soon collapse and it will fall back to its real value.

Conversely, a low P/E ratio may indicate that a share is underpriced or cheap, in which case you may decide to buy it on the expectation that other investors will soon become aware of its fundamental strengths and its share price will rise to its real value.

Generally, a P/E lower than 15 indicates that a company’s shares are currently undervalued, while a P/E ratio higher than 20 indicates that its shares are overvalued.

Take into account the industry and size of the company

This is only a very loose rule, however, as P/E ratios tend to be different based on the industry in which a company operates and on its size.
Technology companies, for example, tend to have higher P/E ratios than other sectors because their growth rates are usually higher and they give investors a higher return on equity.

Article By CA CMA CFA Faculty Aaditya Jain

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