The rule of investing in stock is “Buy cheap, Sell high”. The essential thing here is to know what is cheap and what is expensive i.e. knowing the value of a stock. When it comes to valuing stocks, the price-earnings ratio in short P/E ratio is one of the oldest and most extensively used indicator.
Mathematically the P/E ratio is simple to calculate but quite difficult to interpret this indicator. The difficulty in interpreting indicator has often lead investors to misuse this term and place more emphasis in the P/E than required.
Mathematics of P/E Ratio :
The P/E ratio of a company is arrived by dividing closing price of the share on a particular day with its latest earnings per share (EPS),
P/E Ratio =Market Price of share / EPS
* EPS is the net profit divided by the number of outstanding shares.
Most of the time, the P/E is calculated using EPS from the last four quarters. This is also known as the trailing P/E or historical P/E. Another variant of the P/E called forward (leading) P/E comes from estimated earnings expected over the next four quarters. The objective of such type of P/E ratio is an effort to factor in the projected growth of a company. The important difference between these two are one is calculated on actual data hence is accurate and other is based on projected EPS hence always not precise.
Analysts have diverse opinion when its come to calculating P/E of loss making companies i.e negative EPS. Some say there is a negative P/E, others give a P/E of 0, and while most just say the P/E doesn't exist.
The P/E ratio fluctuates significantly depending on economic conditions and also vary widely between different companies and industries.
Using the Ratio :
Conceptually, a stock's P/E tells us how much investors are willing to pay per rupee of earnings. This is why it's also called the "multiple" of a stock. In other words, a P/E ratio of 10 suggests that investors in the stock are willing to pay Rs.10 for every Rs.1 of earnings that the company generates. However, this is a far too simplistic way of viewing the P/E because it fails to take into account the company's growth prospects.
(i) Growth in earnings: Although the P/E is usually based on historical earnings, the indicator is more than a measure of a company's past performance. It also factor in market expectations for a company's growth. One must remember, stock prices reflect what investors think a company will be worth in future. A high P/E ratio suggests here the stock is in great demand, or the company has bright growth prospect.
If a company has a P/E higher than the market or industry average, this means that the market is expecting big things over the coming times. A company with a high P/E ratio will eventually have to live up to the high rating by substantially increasing its earnings, or the stock price will need to drop.
The reduction in the P/E ratio is a common occurrence as high-growth companies consolidates their reputations and turn into blue chips.
(ii) Valuation of stock: Cheap or Expensive? :The P/E ratio is a much better indicator of the value of a stock than the market price alone. For example, all things remain equal, a Rs.10 stock with a P/E of 75 is much more "expensive" than a Rs.100 stock with a P/E of 20. When a stock's P/E ratio is high; the majority of investors consider it as pricey or overvalued. Stocks with low P/E's are typically considered a good value. However, studies done and past market experience have proved that the higher the P/E the better the stock. There are limits to this form of analysis - one can't just compare the P/Es of two different companies straightway to determine better value of the two stocks.
To determine whether a particular P/E is high or low one should take into account following two main factors:
1. A high-growth company may be cheap even at very high PE multiples. If projected growth rates don't justify the P/E, then a stock might be overpriced. In this situation, all one have to do is calculate the P/E using projected EPS.
2. It is only useful to compare companies if they are in the same industry. For example, utilities typically have low multiples because they are low growth, stable industries. In contrast, the technology industry is characterized by phenomenal growth rates and constant change. Comparing a tech company to a utility is useless. You should only compare high-growth companies to others in the same industry, or to the industry average.
Limitation of the P/E :
P/E analysis is only valid in certain circumstances. Some factors that can undermine the usefulness of the P/E ratio include:
1. Earning is accounting figure that is governed by accounting rules that are change over time and differ country to country. On many occasion EPS is twisted depending on how one keeps books.
2. P/E ratios tend to be lower during times of high inflation because the market sees earnings as artificially distorted upwards. So inflation limits the usefulness of past information today.
3. A high P/E ratio, does not necessarily indicate a bright future for a company; share price of a closely held company are some time hooked at very high or low level, and since these are seldom traded, an unrealistically high or low P/E ratio can be sustained over time.
4. A stock isn't necessarily cheap when it has a low price-earnings (PE) multiple, though PE is a useful parameter. Rather, it could mean that the market believes the company is headed for trouble in the near future. Stocks that go down usually do so for a reason. It may be that a company has warned that earnings will come in lower than expected. This wouldn't be reflected in a trailing P/E ratio until earnings are actually released, during which time the company might look undervalued.
Summary:
A decision to buy or sell a stock should never be made solely on the basis of the P/E ratio. It should always be read along with various quantitative and qualitative factors that impact the company.
1. One should obtain some idea of a reasonable price to pay for the stock by comparing its present . P/E to its past levels.
2. One should find out what is a high and what is a low P/E for the individual company.
3. One should compare the P/E ratio of the company with that of the industry and with pear companies.
4. The average P/E ratio over time is useful to judge the reasonableness of the present levels of prices.
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