Understanding PE ratio in brief

What is PE Ratio?

PE ratio compares a company's current stock price to its earnings per share or EPS.

A PE ratio is calculated by: - Market price per share / Earnings per share

PE ratio tells you how much times the earnings you are paying for the company.

Investors use PE Ratio for:

• Comparing stock prices of similar companies to find the most bargained stock.

• To find if the stock is appropriately priced or overvalued.

• Decide, based on its value, if they should buy, sell or hold any particular stock.

Example: TITAN earns 35 Rs, and its MPs is 2600 Rs, so its PE ratio is 2600(MPS)/35(EPS)= 74. Which means you are paying 74 times its earnings to buy the company.

PE ratio tells you how much return the company is generating on your investment.

Example: Continuing the above example where the PE ratio of Titan is 74. It means to earn 1 Rs effectively, you are paying 74 Rs. So, the return that company is generating on an investment of 100 Rs is 1/74*100 = 1.35%.

When can you buy shares at expensive PE Ratios?

Suppose there is a company whose PE ratio is 50 or above, like TITAN, SYMPHONY, ASIAN PAINTS ETC, which may look costly but say if there is growth, then you can still buy at a higher PE Ratio. Say the company's EPS in Year 0 is 10, PE 50, so MPS will be 500. But, if its earnings double to 20 next year, its PE will be effectively 25. And subsequently, if earnings shoot up to 40, then the PE effectively will be 12.5. So, if you are betting on growing companies, then sometimes buying at expensive PE could be a wise decision.

In such a case you can look for the PEG ratio which discovers the stock price considering its growth in earnings.

The PEG ratio is calculated by: Price-Earnings (PE) / EPS Growth

A company having a PEG ratio of below 1 is considered undervalued.

In such a case, Titan is having PE ratio of 74 and its PEG ratio is 74/20 = 3.7 so it is expensive,

Whereas, IPCA labs have an expensive PE ratio of 35 but its PEG ratio is .99 so it is undervalued.

When should you not rely blindly on PE Ratio?

So, the PE ratio is considered one of the best measures for evaluating stocks.

And many investors value a stock solely by pe ratio.

But it might give a distorted view.

Example:

There are two companies, A and B.

Company A is earning Rs 100000 by Rs 10 lakh investment, and it has 10000 shares, so its EPS will be 100000/10000= 10 Rs, and its market price is 130 Rs. So, its PE ratio will be *130/10 = 13. (Market price / earnings per share)

Whereas company B is earning Rs 100000 by 5 lakh investment and its number of shares is 10000, so even if its EPS will be 100000/10000= 10 Rs, but its market price is Rs 200, then its PE ratio will be *200/10 = 20.

As per the PE ratio concept company B becomes unattractive as it is available at a higher valuation. But we should also consider the return on capital employed and what the company is earning. From that, we know that the premium it enjoys is because of 2x earnings on the same capital, and hence higher PE ratio for the same is justified.