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How to use the P/E ratio for investing ?

Market Live brings in the Stock Market Tutorial which explains the basics of Fundamental Analysis and Investment Valuation. Whether it is about Reading Balance Sheets or about understanding the important valuation indicators like P/E ratio or EPS – Get all the fundamental analysis aspects being explained in a simple manner here.

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The Price to Earnings (P/E) Ratio is one of the most widely employed valuation statistic of a company. This important ratio is also referred to as Price Multiple or Earnings Multiple of a company.

Before beginning, you might be interested to read the Part I of this series – What is the P/E ratio ?

In this tutorial, we shall see how we can use this important ratio to valuate the companies or stocks belonging to them.

Significance of the P/E ratio ?

  • The PE Ratio is the most important of all valuation tools.
  • The PE Ratio gives an investor a better understanding of a company’s value.
  • Essentially the PE Ratio calculates the “Payback Period” of an investment.
  • The Price/Earnings Ratio (“PE”) is used by investors to assess how many years it will take them to get the value of their investment back. P/E ratios are a quick way to sort out the leaders within the same sector.

How to use P/E ratio for investment valuation ?

A low P/E ratio, shows that the company has high earnings relative to the current market price of its stock. Thus it may indicate that the market has currently undervalued the stock. Hence such stocks can be seen as potential buys at its current price. A P/E between 10 and 20 is usually considered reasonable by most investors’ standards.

A two fold advantage is seen with choosing lower P/E stocks by cautious investors:

  • If a stock is currently trading at a low market price relative to its earnings, and if the research shows that it is fundamentally in a good sector, then its price will probably eventually go up.
  • Again, if the market conditions are very turbulent and if it falls drastically, the price of the lower P/E stocks may not fall as much as the price of the stocks with higher P/E ratios.

Similarly the higer the P/E ratio, the riskier the stock is likely to be. Hence when P/E rises to 50 to 60 or even higher, it clearly indicates that the current price has become unrealistic.

Comparing P/E ratios

It’s usually a practice to make a comparison of the P/E ratios of one company to other companies in the same industry. For example consider two companies A and B, that are both trading at Rs.100 per share. Suppose that company A has got a Rs.10 as its EPS and company B has got Rs. 5 as its EPS. Then we find that Company A has a P/E ratio of 10, while Company B has a P/E ratio of 20. This means that company A is clearly cheaper when compared to company B. If all other factors for these companies are found to be equal, then the investors have to choose company A for investing there money in.

It doesn’t really work out if one makes a comparison of P/E ratios between companies belonging to different industry sectors. Different industries have different average P/E ratios. For example, technology companies may sell at an average of 40 p/e, while textile stocks may only trade at an average of 8. It is very important to understand these differences when comparisons are made. Tech stocks in the past usually had a higher growth rate and thus high returns on equity, while other sectors like textile, or auto ancillaries might trade at a much smaller earnings multiple.

It is also a practice to compare the current P/E of a company with its own historical P/E ratios. This comparison indicates how expensive the stock has become over the past year or any other period for which the comparisons are made. If the current P/E ratio is significantly less than the average of the past P/E ratios for the same company, it could indicate that by historical standards the stock is undervalued.

Higher P/E or Lower P/E ?

It is really difficult, to make a rule on what is high or what is low, for P/E ratios of companies. Companies might have a low P/E for a reason, and the trick is finding out whether that reason is likely to be short-term or permanent. Conversely, not all companies with a high P/E are overvalued. A high P/E says that investors expect the stock to be a strong performer and are willing to pay a premium. A lower P/E might indicate that the market has less confidence in the company’s long-term potential.

How P/E ratios can be in-effective ?

Many believe that a stock should never be bought solely because its P/E ratio is lower. There might be various reasons for why market has discounted the price of the stock currently.

Higher P/E ratios are generally found to be occuring as a result of bull markets. Thus in a continuing bull market, many stocks could be overlooked by investors, just because its P/E seems to be too high.

Similarly lower P/Es might have occurred as a result of bear markets. There is no protection rule that protects a stock trading at 8 to 10 times earnings, from falling further and trade at 3-4 times earnings.

Fundamentally, P/E ratios can be inaccurate, because of an inaccurate earnings measure. Many times, financial statements may themselves be distorted or manipulated, giving rise to faulty earnings estimations.

Often, P/E ratio calcuations become outdated. For example, if the latest earnings report of the company was published more recently, then the P/E will be based on this information. However, if that report was published many months ago, then the P/E is also outdated. Also P/E gets outdated, if the number of shares outstanding might have changed, because of a change in shareholding pattern of the company.

Also see : What is the P/E ratio ?



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