Q. I am a 24 year old working professional. I have just started my first job and I am currently investing solely in the National Pension Scheme. I wish to allocate a small portion of my income in blue-chip stocks, however I am still learning about the factors which one should consider before investing in stocks. I understand from my colleagues and older relatives that one of the most important factors while investing in stocks is PE ratio. I tried reading about it on the internet, however, I am still unclear about it. Can you please elaborate on what PE ratio is and what should I concede?
Maulik Bhatia, Mulund, Mumbai
Prior to understanding what price-to-earning ratio (“PE Ratio”) is, it is critical that we understand what is earnings per share (“EPS”). EPS measures a company’s profitability on a per-share basis and is a number investors frequently use to appraise a stock or company.
EPS is calculated by subtracting from the net income (profit) of a company dividends declared by the company and thereafter dividing the result by the total number of outstanding shares of the company.
For the purposes of calculating EPS one needs to first determine the net income of the company. A company’s net income is the amount of money left over in a reporting period after all cash and non-cash expenses have been subtracted.
Let us understand EPS using an example: X company reported net income of INR 100 crore in its most recent fiscal year, it has 10 lakh outstanding shares and the company has not declared any dividend. In this case X’s EPS would be 100,00,00,000 (net income) divided by 10,00,000 (number of shares) = INR 1000 per share.
PE ratio indicates numerically the link between a company's stock price and its earnings per share. PE ratio is obtained by dividing a company's current stock price by its EPS. PE Ratio is also called price multiple of earnings multiple.
Investors and analysts use PE ratios to assess the comparative value of a company's shares in an apples-to-apples comparison. It can also be used to compare a company to its past performance or to compare broad markets over time or to one another.
Now, let us understand PE Ratio using the illustration stated above. We had calculated the EPS as INR 1000 per share. Shares of X are trading at a price of INR 20,000 per share. In this scenario the PE Ratio for X would be: 20,000 (price per share of X) divided by 1,000 (EPS of X) = 20
PE ratio of X is 20.
How to evaluate companies using PE ratio?
As an investor you need to assess the type of company you are investing in and identify the industry in which it is situated before you use PE Ratio to determine if it is worth investing in. In some industries or asset classes, a high PE ratio might be extremely detrimental for your investment in the long run.
Ideally an investor will want the PE Ratio to be low especially if he is following a value investment strategy. On the other hand if an investor is looking to invest in growth stocks he will have to bear with high PE stocks since a number of investors will probably want to acquire a company's shares if its earnings soar.
Although the P/E ratio is helpful, you shouldn't base all of your stock purchasing decisions on it. For some businesses with low P/E ratios, the ratio may decline even further, and vice versa. An investor should ideally use PE Ratio to analyse the following three factors:
Competitors in a given industry typically have similar cost structure and revenue streams. Accordingly, PE ratios in a particular sector ought to be similar, and positive variations are probably indicative of the strength of the company's operations or its potential for expansion. A corporation may be an excellent investment if you believe its business is superior yet its P/E ratio is low.
One of the best strategies to prevent purchasing stocks with permanently low PE Ratios is to look at the stock's PE Ratio history. What is the precise catalyst, if a value stock's PE Ratio is unfavourable and has been so for years, then there is low probability that it will improve in the future unless there is a monumental change in the company’s strategy. High PE Ratio may be acceptable to investors if they anticipate further expansions of the company in future and especially if the company is still in the process of making a name for itself and is in the early stages of its life cycle.
You can compare the growth of similarly situated companies by figuring out a company’s P/E ratio as a multiple of the company's projected earnings growth rate because a company that is growing quickly may be worth a high PE Ratio.
PE Ratio is an important factor in determining whether a company is performing well, especially in comparison to its competitors in the same industry. However, it is important to note that all investments in the stock market are subject to market risk and no single parameter can guarantee you risk-free investment. Many times a new entrant to the industry can make the existing companies redundant.
For example, the stock of US car manufacturers have suffered a lot since the listing of Tesla. For retail investors investing in mutual funds in place is an optimal strategy to reduce risk.
Kuvera is a free direct mutual fund investing platform.
Note: This story is for informational purposes. Please speak to a financial advisor for detailed solutions to your questions.