Assume there are two companies A and B, operating in the same sector. If PE of A is 30 and PE of B is 22, then B is considered to be a better buy, as the market price has not gone up to reveal the earnings prospect of the company. But A is considered to show higher growth prospects as compared to B.
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 situation also applies to stocks.
If you buy a share of company A for Rs. 100 but later on find out that the share of company B, with better earning prospects is available for Rs. 60. It is bound to disappoint you. So then how do you find out quality bargains amongst stocks? How can you decide if the present 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 earning 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
Assume there are two companies A and B, operating in the same sector. If PE of A is 30 and PE of B is 22, then B is considered to be a better buy, as the market price has not gone up to reveal the earnings prospect of the company. But A is considered to show higher growth prospects as compared to B.
How does PE help?
Understanding of PE gives the investors an idea if the stock has sufficient growth potential. Stocks with low PE can be considered as good bargains as their growth potential is still unknown to the market. If the PE is high, it can clearly warn of a very over-priced stock. It means the stock’s price is much higher than its actual growth potential. So these stocks are more liable to crash down drastically. This was evident in the recent market crash when the stocks of all Reliance companies fell sharply. This will allow savvy investors to sell their holdings before the stock price crashes.
Drawbacks of PE ratio
Interpretation of PE ratio is highly dependent on comparison of the company with its peers. Also PE that is considered very high in certain sectors can be considered to be very low in other sectors. E.g. companies in IT and telecom sectors have higher PE ratio than the companies in manufacturing or textile sectors. Also PE ratio is not totally neutral. Any major announcement of a major order or acquisition by the company will certainly push up its PE. On the other hand, a low PE may not indicate a good buy but could signify more serious issues facing the company. So it is very important to perform a thorough research into the background of the company, before investing. Besides EPS itself is assumed, as it forecasts future growth based on past performance. But there is no guarantee that the company can continue to maintain its performance each year. Also the sector in which the company is operating may experience problems as was recently seen for the IT sector. So PE ratio cannot be considered to be the reliable indicator of cheap but good stocks.
PE ratio is one of the most important ratios when it comes to stock selection. It indicates the amount that is right for the investor to pay for buying the good stocks. It can be calculated by dividing the market price of the share by its EPS. Lower PE indicates good bargain, while higher PE indicates over-valued stock. But remember, PE ratio is not a fool-proof method of stock selection. It has many limitations, so it is very important for an investor to carry out a through research into the company’s performance before investing.