Ever wondered how great investors predict the value of a company or identify a multibagger stock? There are multiple parameters that help them come to a conclusion before they start investing. One of the major criteria that they look at before investing in a particular stock is the P/E ratio of the company. Now, let’s define the P/E ratio in the simplest terms possible. Here the P stands for “Current Market Price (CMP) of a single share” and E stands for “Earnings Per Share (EPS).” The P/E ratio helps to understand the company’s worth today and the growth anticipated based on how its share prices are relative to its earnings per share. Let’s explain with an example:
PE calculation and example:
Let’s understand the concept with a simple concept.
- Ravi & Vinod started their own clothing business. Both of them invested a starting capital of Rs.20,000 in the business.
- Each of them gets 5000 shares of Rs.12 each.
- The capital structure
- - Total Capital: Rs.40,000
- - No of shares: Rs.10,000
- - Shareholder: 2
Now, you have a successful business for 1 year by generating a profit of Rs. 30,000. As a result, each owner gets a 50% of the profit which comes up to Rs.15,000. So, the earnings per share calculation will be:
EPS = Earnings / No. of shares
= 15,000 / 10000
= Rs. 1.5
This will give both the partners an idea about the earnings of each 5000 shares. Now that they know that they are earning a profit, Ravi & Vinod tell their success stories to their friends. Now, one of the friends gets excited and decides to invest in this profitable business. So, he comes to the partners and decides to buy 1000 shares at a cost of Rs.15/share ( he cannot buy at Rs.12 as the business is a success).
As a result, the friend added a premium of Rs.3 over your base rate of ₹12 per share.
Then, the P/E ratio will be:
P/E = Price / EPS
This means the friend is happy to pay 10 times extra to buy the shares and get an opportunity to earn an equal proportion as Ravi & Vinod. As P/E is also called a value calculator, in this story it is 10X. So here the new shareholder is willing to pay 10x.
Now the question arises, what is the ideal PE ratio?
If a P/E ratio is high, investors deduce that the stock is overvalued and sell the shares or refrain from buying. In case the shares are undervalued, investors purchase them at lower rates to claim profits when the unrealised value is tapped. According to historical data, ideal P/E value ranges between 20-25.
Remember that a high P/E stock can always gain momentum in the market. However, a question that is often asked is “How high is better”? The answers depend more on investors. A P/E will never be high if more people are not thinking about these stocks. This is one of the main reasons why some stocks are overvalued or sell at a premium. So one should always remember the management quality before investing for good returns.
Types of PE ratios:
Depending on the two different ways of calculating EPS, there are two types of PE ratios – Trailing and Forward-looking.
Trailing Price to Earnings:
The trailing P/E depends upon the past performance of a company by dividing the recent stock price by the total EPS earnings over the past year. It is one of the most reliable and popular PE metrics, using actual data of the company’s profits. Prudent investors take the trailing PE as the basis of most of their financial decisions as the future earnings estimates could be unreliable. However, investors must remember that a company’s past performance does not necessarily guarantee its future behaviour.
Also, the trailing P/E ratio is not reflective of real-time company scenarios. While trailing P/E ratios include the latest movement of the price of a company’s stock, the earnings used are still the last reported quarterly earnings. So, while the stock price that moves every few hours might capture the latest updates within the company, the trailing P/E ratio remains more or less constant as the EPS is dated. For this reason, some investors prefer the forward P/E over the trailing PE.
The forward (or driving) P/E utilises estimated future income as opposed to trailing earnings figures. It is also known as the estimated cost to earnings. This indicator is valuable for providing a base of comparison between the current income and future income and gives a clearer image of what and how the company’s profits will pan out.
Though FPE is a reliable measure in assessing the future earnings of a company, FPE has certain limitations. Organisations can manipulate by underestimating their earnings in an attempt to outperform the estimated PE ratio when the quarterly gains are announced. Or overestimate P/E to push stock prices higher and miss earnings estimated. Such estimation causes a stock to be overvalued or undervalued, and investors never realise the expected returns.
Using PE ratios to determine Investment Strategies:
PE ratios help in share selection. A low trailing P/E of a promising company’s stock could be an excellent investment. While a high P/E usually indicates that the price is overvalued compared to the company's earnings. However, several high-growth companies have higher P/E ratios:
|Company||CMP (Rs)||PE (X)||Market Value (Rs m)|
|ADANI TOTAL GAS||3.595.0||784.3||3,953,817|
|ADANI GREEN ENERGY||2,347.3||765.1||3,718,199|
|BAJAJ HOLDINGS & INVESTMENT||6,868.0||338.9||764,364|
However, if the economy is booming, a high ratio does not mean the shares are overpriced as the overall market sentiment is positive. So, while P/E ratios are used to select stocks, careful estimation and relative assessment of the total ratio reap profits in the long run.
Also, did you know that some companies have a Negative P/E ratio? And why do they? A negative P/E ratio happens when a company has negative earnings or loses money. If a company’s earning per share is lower than zero, then the stock can have a negative P/E ratio. Any company (big/small) can have a negative P/E ratio. However, if any company has a consistent negative P/E ratio then it is not generating enough money.
Sector-wise PE ratios:
PE ratios could vary from industry to industry. A plausible way of determining if a sector or industry is overpriced is when the average PE ratio of all the organisations in that sector or industry has values much more than the historical P/E average.
While investing, stock marketers gauge the market value of the industry, in general, to understand how a sector is faring and then compare it to the individual company’s stock price to make a calculated judgement.
|Interpretation of the PE ratio depends upon the comparison of a company alongside its peers and competitors. It is wise to keep in mind that a particular PE, which is considered high in specific industries, can be very low in others. For instance, IT players and telecommunication companies have higher PE ratios compared to textile or manufacturing sectors.||Another thing to understand is that whenever there is a significant acquisition by a company, this pushes up its PE. On the contrary, a lower PE may indicate bad news as it can signify serious issues being faced by the company. Thorough research is to be done about a company or a sector before taking up a significant investment decision.||PE ratio is not an end-all indicator of a company’s annual performance as the performance is subjected to other external factors such as economic conditions, leadership efficiency, operational challenges, competition, and more.|
PE ratio is an essential tool to understand the company and market behaviour at any given point in time. Investors and companies rely on this ratio to make financial decisions and effectively value their stocks based on the share market Value and earnings to date or future earnings. PE ratio, though a comprehensive metric to evaluate a specific company’s worth, can be inconsistent at times due to fluctuating stock prices or earnings.
Now that we know what PE in the stock market is, a well-researched and informed approach should be followed when investing. So once you are done with your research, take your first step in investing by opening a Demat account.