You must have heard the term P/E ratio a lot of times, but do you know what it really means and what do PE ratio figures imply? Well in this article, we are going to talk about the same.
What is PE Ratio?
P/E ratio means price to earnings ratio. For example, if the current price of a stock is Rs. 100 and it has earned Rs. 5 per share (EPS – Earning Per Share) for its shareholders in the past 12 months. The P/E ratio works out to be 100/5=20. Now what does it imply?
When we say a P/E ratio of 20, it means we are willing to pay Rs. 20 for each rupee the stock is earning. When the PE ratio is lower, it indicates that the stock is cheap and when the PE ratio is high, it means that the stock is expensive. PE ratio can be a factor to decide which stock to choose when the market capitalisation, growth rate, debt, risk, consumers, market segment, etc. is same for given two companies.
You cannot compare two stocks if they fall into separate segments. For example, capital intensive stocks like infrastructure, metals, auto, etc. would usually have lower PE ratio than the others like the ones offering services. If a company seems to be promising a steady growth in earning, you might want to pay a premium price to own that stock, as you are sure you would get back you money early. You also might want to pay a higher price for a stock which seems less risky/ which has delivered steady performance in the past. A debt ridden company’s PE may look good, but the debt of the company is not accounted for, in the PE ratio.
PE ratio where earnings of past twelve months is considered is called trailing PE ratio. But the past performance of the of a company may or may not be repeated.
PE ratio of an Index is the weighted average PE ratio of the stocks the index constitutes. A low PE of the Index indicates an undervalued market and a higher PE ratio indicates an overvalued market. An overvalued market gives you an exit opportunity, opportunity to book profits and shift your funds to debt, as the market may see correction and as a result may come down. An undervalued market indicates that you should invest into equities to participate in the stock appreciation. PE below 16 is considered a lower PE ratio for the Index and a PE higher than 21 is considered a higher PE ratio. Here is a chart showing how PE of the Nifty Index has been changing in last 10 years.
There is another term called a forward PE ratio which is based on the expected earnings of a stock in the coming 12 months. The forward PE ratio is based on analysis by research analysts, which can be speculative.
P/E ratio should not be used as a sole criteria to buy stocks. If PE ratio of a stock has dipped, you need to find out why has this happened, rather than believing, it is a good time to buy the stock.