The price to Earning (P/E) Ratio is one of the most important relative valuation indicators for investment purposes. What does relative valuation mean? Well, it is a business valuation technique that is used to find the company’s worth among its peers. Besides P/E ratio, Debt to equity ratio, Price to book ratio, PEG ratio are some of the useful financial ratios. In today’s article, we will talk about the P/E ratio and things to keep in mind before investing in high P/E stocks.
How to Find Price to Earning Ratio (P/E)?
Dividing the share price of a company with its EPS (earning per share) gives price to earnings ratio(P/E ratio).
P/E ratio = Share price/EPS
To know the earning per share of the company, divide the total earnings of that company by the total number of outstanding shares.
Earning per share = Total earnings/ Total number of outstanding shares.
Assume that there is a company called XYZ limited. The share price of this company is
Rs. 200/- and its yearly earnings stands at Rs. 35 lakhs. There are 4 lakhs outstanding shares of XYZ limited. What is the P/E ratio of this company?
Earning Per Share = 3500000/400000 = 8.75
Price to Earning Ratio = 200/8.75 = 22.85
The PE ratio of XYZ Ltd is 22.85. That means investors are willing to pay Rs.22.85 for every rupee the company earns.
Instead of doing all the above calculations, you get the P/E ratio of listed companies through the NSE India website.
There are two types of P/E ratios. They are trailing P/E which is also called historical P/E and the other one is forward or leading P/E. Trailing P/E is calculated by dividing the present share price by the sum of EPS of the previous four quarters. On the other hand, forward P/E uses EPS estimates for the next four quarters.
Investing using P/E ratio
P/E ratio tells about how much an investor is willing to pay per rupee earnings. In the above case of XYZ ltd, investors are willing to pay Rs. 22.85 for every Rs. 1 the company earns. The P/E ratio accounts for the future growth of the company. So, the P/E ratio reflects the optimism and pessimism of the market. Companies that are in the growth stage will have a high P/E ratio because of their earnings. During the 90s, Microsoft’s P/E ratio was above 100. But currently, it is hovering around 37. The reason is that now the company is so big, it can’t grow as rapidly as earlier. Since the growth speed reduced, revenues fell and the PE ratio also dropped.
To determine the fair valuation of a stock, its PE ratio is compared with its peers and the benchmark index (Nifty50, Sensex). PE ratio is used to determine whether a stock is cheap or expensive. For example, assume two companies A and B. The stock price of A is Rs.15 and the PE ratio is 80. On the other hand, the stock price of B is Rs.200 and the PE ratio is 20. So, which company is more expensive the one with a stock price of Rs.15 or Rs. 200? We cannot determine that using stock prices, the PE ratio should be taken into account. A is more expensive than B. Yes, the stock price of B is higher than B but the PE ratio of A is higher than B.
Should you invest in high PE ratio stocks?
The PE ratio alone is not enough to invest in any company’s stock. In the above example, we found that investors are willing to pay Rs. 22.85 to get Rs. 1 share in the company’s earnings. Here if you observe, investors are confident about the future of the company and that is why they are paying more. If the earnings fall, the PE ratio reduces, and investors confidence reduces. This leads to a fall in stock prices.
High PE ratio companies grow if their earnings match with investors expectations. If the earnings fall, the PE ratio falls and it may result in the devaluation of the company.
Along with earnings, you should consider the industry to which the company belongs. Different industries have different PE ratios. For example, you cannot compare the PE ratio of two companies that belong to various industries/sectors. Generally, few industries have a higher PE ratio than others. So, the final answer to whether to invest in high PE ratio stocks depends on the industry to which it belongs and its future earnings.
What are the factors that affect the PE ratio?
The PE ratio formula is determined using stock price and earnings. So we need to know what are the factors that affect the stock price and the company’s earnings.
- Earnings growth
Investors like to put their money in companies whose earnings are growing consistently. Investors expect a steady growth trajectory from these companies. If a company’s earnings are good investors love to pay more to get a share from its earnings.
- Company’s Profitability
Earnings growth is not enough to determine profitability. Not all companies can convert earnings into profits. The ones who have this capability of converting growth to profits will have a high PE ratio.
- Return on Equity (ROE)
ROE determines whether a company is efficiently turning investors equity into profits or not. Investors prefer to invest in companies with high ROE after considering their debt. The companies with high ROE tend to have high PE too.
Macroeconomic factors can affect entire markets all over the world. Policy makers’ decisions at the micro-level can impact the stocks. If these factors are in the favor of any company, it boosts the company’s PE ratio. If it is against the company, it results in a fall of the PE ratio.
Things to Keep in Mind Before Investing in High P/E Stocks
Most of the investors use the PE ratio as a criterion to invest in stocks. But, if not properly analysed, investors may end up investing in high valued stocks.
- Know why the share price is increasing
When the share price of a company is increasing, determine whether it is due to the company’s performance or because of external factors. If company performance is not the factor the demand may reduce in future and share price may fall.
- Research on EPS
Earning per share is calculated using company earnings and outstanding shares. If a company issues more shares, the EPS ratio will fall. Since EPS is the denominator in the PE ratio, a fall in EPS boosts the PE ratio. Similarly, if a company has lesser earnings, EPS will be low and this, in turn, increases the PE value. It is important to each financial aspect individually before arriving at the final investment decision.
The stock markets are volatile. Because the P/E ratio is based on the share’s market price, when external factors make markets volatile, the stock price also becomes volatile. This makes maintaining a consistent P/E ratio challenging. As a result, avoid utilising the P/E ratio to evaluate a stock’s demand during moments of significant market volatility.
Invest in companies you understand. Do not invest just by looking at high PE values. Many factors can modify the PE ratio. So, examine each of them individually. Also, use other financial ratios along with PE ratios for better-informed decisions. If you do not know about company analysis, don’t worry. Read our article “Company Analysis for Long Term Investors”
High PE doesn’t mean everything’s going great with the company. Many factors affect the PE ratio. Do not compare PE ratios of companies that belong to different sectors. PE ratio can be used for investment decisions, but do not solely depend on it. Do a complete fundamental analysis for better decisions. By saying this, I will conclude our article “Things to Keep in Mind Before Investing in High P/E Stocks”
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