How P/E Ratio helps you to invest in best stocks?
You would have seen that when I am analyzing a stock or IPO, I would generally indicate Price-to-Earning (P/E) Ratio of the company. P/E Ratio is an important indicator for an investor to determine whether a stock is under priced or overpriced. In this article, I would provide details about Price-to-earning (P/E) ratio, how it works, when to use P/E Ratio, when not to use P/E Ratio and how this parameter would help you determine in selecting the best stock for long term investment.
What is the P/E Ratio of a stock?
Price to-Earning (P/E) ratio is the ratio of how many times the share price to earnings per share (EPS).
Wikipedia defines P/E Ratio as follows
Price to earnings ratio is an equity valuation multiple. It is defined at market price per share divided by annual earnings per share (EPS).
P/E Ratio = Share price / Earnings per share
P/E Ratio explained with two examples
Example no.1 – Computation of Infosys P/E Ratio
- Infosys share price as of 7th May, 2014 is Rs 3,065. Its EPS for Q4-FY2013-14 is Rs 50. Trailing EPS for 12 months would be Rs 200
- P/E Ratio = Share price / EPS
- P/E Ratio of Infosys = 3,065 / 200 = 15
- The means Infosys share price is 15 times priced to annualized EPS.
Example no.2 – Computation of TCS P/E Ratio
- TCS share price as of 7th May, 2014 is Rs 2,166. Its EPS for Q4-FY2013-14 is Rs 27. Trailing EPS for 12 months would be Rs 108
- P/E Ratio = Share price / EPS
- P/E Ratio of TCS = 2,166 / 108 = 20
- Means, TCS share price is 20 times priced to annualized EPS.
Comparing Infosys and TCS, Infosys P/E Ratio is less and Infosys share is underpriced.
How P/E Ratio should be looked?
P/E Ratio should be looked from 3 angles.
- P/E Ratio of the company
- P/E Ratio of the peers (High or low)
- P/E Ratio of the industry (High or low)
P/E Ratio of the company should be always lower, compared to peers and industry. Higher P/E Ratio means, stock is over priced and limited scope for increase in stock price. Also higher P/E Ratio would have major beating during stock market crash.
When you can use P/E Ratio?
- To determine whether a stock is over priced or under priced
- To take a decision to invest in an IPO based on P/E Ratio
- Whether to enter a stock at current price or not
When not to use the P/E Ratio as a basis to buy stock?
- Stock markets are at peak and the stock price has shot up along with other stock prices
- Stock price got beaten up during the market crash
- Not to use during quarterly results as any fluctuation in revenues or profitability for that quarter would impact the stock price
- Not use during any special news about the company that impacts stock price
- Don’t compare P/E Ratio of other industries. E.g. IT stocks have high P/E Ratio compared to Manufacturing companies. You cannot compare manufacturing stock P/E Ratio with IT stock and invest.
Should you buy low P/E Ratio stocks blindly?
Straight answer is NO. P/E Ratio is one of the best tools for stock selection. It is one of the most important ratio to select a best stock. However, there are various other factors which need to be looked into before investing in a stock. Below could be the checklist before selecting a stock. This is at high level and not comprehensive.
- Consistent revenue growth in last 5 years
- Consistent profit growth in last 5 years
- Better forecasting of future growth in revenues and profits
- Finally, consider P/E Ratio and select low P/E Ratio stock for investment.
To continue with the above example, Infosys was a good stock. It has been providing consistent revenue growth and profitability growth in the last few years. It has low P/E Ratio compared to TCS. However, its future growth is in question. Entry of Mr. Murthy has made some impact, however we are yet to see major improvement in the company financial performance.
Conclusion: P/E Ratio is one of the key parameters to check about whether a stock is under priced or overpriced. However, consider all other parameters and low P/E Ratio stocks. These should create good wealth for you in the long run.
If you enjoyed this article, share it with your friends and colleagues on Facebook and Twitter.
How P/E Ratio helps you to buy the best stocks