By Vishweshwar HS, www.showmytrade.com
How do you compare a company like Infosys and ITC? Which company is better for investment? Both belong to a different sector, with different balance sheet sizes, and profitability. We use Price-to-Earnings (P/E) to compare and make better judgments.
The P/E ratio is the most widely-used stock analysis tool used by investors and analysts for determining the stock valuation. P/E ratios are used to find out if a company’s current market price is cheap, fair, or expensive. The company P/E ratio is also compared with that of industry/sector P/E. Further, company P/E compared with a benchmark like the Nifty 50 Index for knowing relative valuation. P/E is also used for historical comparisons of the same company or to compare with other companies in the same industry.
P/E Ratio = (Current Market Price CMP) / (Earnings Per Share EPS)
Where CMP = Current Price of a Stock
EPS = Profit after tax / Number of Outstanding Shares
Example of the P/E Ratio
ICICI Bank, CMP is 291.3 and EPS is 11.9
The P/E Ratio = Rs 291.3/ Rs 11.9 = 24.5X
In simple terms, If ICICI Bank gives the same EPS (11.9) every year, an investor will get back your money in the next 24 years!!!! (That’s the premium you have to pay to buy that stock).
A higher P/E ratio means that a company’s stock is expensive or overpriced. Some investors are expecting high growth rates in the future, so don’t mind buying the stock.
A lower P/E can indicate either that a company's stock price is undervalued. It can also be interpreted as the company is doing exceptionally well relative to its past trends.
Companies that have no or negative earnings do not have a P/E ratio. Negative P/E will not take for valuation purposes.
1) Forward P/E: The forward/leading or estimated P/E uses future earnings guidance rather than trailing figures. Forward P/E is useful for comparing current earnings to future earnings. It helps to have a clearer picture of what earnings will look like – without accounting changes and other adjustments to books.
However, the limitation of the forward P/E is that a company could underestimate or overestimate the earnings. Either beat the street or overestimate and adjust later. Further, independent stock analysts may also provide estimates, which may diverge from the company estimates, creating confusion.
2) Trailing P/E: The trailing P/E dividing the current market price by the Earnings Per Share of the past 12 months. Some investor takes such P/E accurately as it represents the actual declared earnings of a company. The trailing P/E has its limitations, too, as a company’s past performance doesn’t the same in the future. Investment is made in the hope of future earnings and not based on past performance.
Sometimes, Investor wants to know the long-term valuation trends. For example, the P/E 10 or P/E 30 ratio’s average, Usually, stock or sectorial index. It helps the Investor to have long-term pictures, which shows a holistic view of the market.
The inverse of the P/E ratio is the earnings yield. Earnings yield takes into account the absolute value of the P/E ratio. Calculated by dividing the EPS by CMP. Earnings Yield provides an idea about the earning/returns that stock would produce for every Rupee invested by the buyer in it.
If P/E is 25, the Earnings Yield would be 1/25 = 4%. Using Earnings yields are compared with Govt securities if the return is high, some investors invest in that equity stock.
PEG ratio is measured by dividing the P/E ratio by the earnings growth rate (PEG ratio). If the Price Earning to Growth (PEG) ratio is less than 1, the stock is assumed to undervalue, and the PEG ratio is more than 1. The stock is considered to be overvalued.
Valuation analysis is to find whether the stock of a company is currently,
(i) cheap or undervalued (right time to buy),
(2) fair value (rightly priced), or
(3) expensive or overvalued (right time to sell) valuations.
P/E ratio is essential in Valuation analysis. Those stocks which satisfy the criteria of excellent financial performance and attractive valuations should be analyzed further. Thus learning P/E ratios and other related ratios are essential to make final buying or selling stock decisions.
How to Build a Highly Profitable Portfolio for Individual Investor?
What Are Different Styles Of Investing?
Kindly share your comments on the “What Is Price-to-Earnings Ratio or P/E Ratio?” below. Any suggestions regarding this article will update in the next edition.
Thanks for reading.
Good Earning!
