The P/E or ‘Price by Earnings per Share’ ratio is one of the most important ratios when it comes to fundamental analysis. It assesses the market valuation of the price. In other words, it tells us how the market currently sees the stock
What does the P/E ratio signify?
A stock's P/E tells us how much its investors are willing to pay per rupee of earnings. For this reason it's also called the "multiple" of a stock. In other words, a P/E ratio of 20 suggests that investors in the stock are willing to pay Rs20 for every Re 1 of earnings that the company generates.
What is the ideal P/E ratio?
The ideal P/E ratio lies between 10 and 30. For most industries, a value of around 20 is the most appropriate. However, while judging the P/E ratio, it is very important to look at the industry’s average P/E ratio as well.
What does a high P/E ratio mean?
If a company has a P/E higher than the market or industry average, this means that the market is expecting big things over the next few months or years. A company with a high P/E ratio will eventually have to live up to the high rating by substantially increasing its earnings, or the stock price will need to drop.
A good example is Microsoft. Several years ago, when it was growing by leaps and bounds and its P/E ratio was over 100. Today, Microsoft is one of the largest companies in the world, so its revenues and earnings can't maintain the same growth as before. As a result, its P/E had dropped to 43 by June 2002. This reduction in the P/E ratio is a common occurrence as high-growth start ups solidify their reputations and turn into blue chips.
What does the P/E ratio for a value company look like?
Value companies are fundamentally strong companies whose market potential is yet to be recognized. Stock market investors have yet to discover these companies. They are characterized by high growth rates and low prices. For this reason, the P/E ratio for a value company is generally lower than the average industry value.
Why is a high P/E ratio dangerous?
Not all fast growing companies can sustain their high growth rates. For example, Reliance communications was trading in 2008 at 800/- and a P/E ratio of 63.84. Today its per share price is INR 60 and P/E ratio is negative*! In fact, most companies with very high P/E ratios are overvalued and are known to collapse! For this reason, the P/E ratio should not be used for high growth companies. Use thePEG ratio instead.
*What does a negative PE ratio signify?
A negative PE ratio means that a company is losing money. While a negative PE ratio is bad in most situations, it is not a sure indicator. Some companies have seasonal sale cycles. For example, companies making festive decorations, lightings etc will have sales only in the festive season, but costs all round the year. So they will have a negative EPS and conversely, a negative PE ratio.
Summary of the P/E ratio
Optimal Range: 10 – 30
Check Points
1. The P/E ratio is less than 30 if growth is less than 30% pa.
2. Most leading and coincident indicators show approximately the same trend as the P/E ratio.
3. The intrinsic value is not less than the stock price.
The P/E ratio in action
Below is a graph showing the price and the P/E ratio of Infosys over time. As is visible, the P/E ratio and price show the same movement! This is, of course, an ideal scenario. A lot many deviations happen when we take into account interplay between the various fundamental factors. We will discuss them gradually.
Read more about the P/E ratio here:
Wikipedia
http://en.wikipedia.org/wiki/PE_ratio
Times of India
http://timesofindia.indiatimes.com/Understanding-P/E-Ratio/articleshow/24372323.cms
Investopedia
http://www.investopedia.com/terms/p/price-earningsratio.asp
About.com
http://economics.about.com/cs/finance/l/aa030503a.htm
The P/E ratio is given by:
P/E ratio = market Price per share/ Earnings per Share.
What does the P/E ratio signify?
A stock's P/E tells us how much its investors are willing to pay per rupee of earnings. For this reason it's also called the "multiple" of a stock. In other words, a P/E ratio of 20 suggests that investors in the stock are willing to pay Rs20 for every Re 1 of earnings that the company generates.
What is the ideal P/E ratio?
The ideal P/E ratio lies between 10 and 30. For most industries, a value of around 20 is the most appropriate. However, while judging the P/E ratio, it is very important to look at the industry’s average P/E ratio as well.
The P/E ratio band changes sector wise. For e.g. IT, Pharma, MNCs, Zero Debt Companys will always trade in the higher band may be higher than 20 while commodities like metals, sugar or PSU banks will trade generally in lower band below 10.
What does a high P/E ratio mean?
If a company has a P/E higher than the market or industry average, this means that the market is expecting big things over the next few months or years. A company with a high P/E ratio will eventually have to live up to the high rating by substantially increasing its earnings, or the stock price will need to drop. A good example is Microsoft. Several years ago, when it was growing by leaps and bounds and its P/E ratio was over 100. Today, Microsoft is one of the largest companies in the world, so its revenues and earnings can't maintain the same growth as before. As a result, its P/E had dropped to 43 by June 2002. This reduction in the P/E ratio is a common occurrence as high-growth start ups solidify their reputations and turn into blue chips.
What does the P/E ratio for a value company look like?
Value companies are fundamentally strong companies whose market potential is yet to be recognized. Stock market investors have yet to discover these companies. They are characterized by high growth rates and low prices. For this reason, the P/E ratio for a value company is generally lower than the average industry value.
Midcap and Smallcap companies, which have the potential to become value companies in the future, sometimes have very low P/E ratio. However, a very low P/E ratio may prove dangerous and may indicate that there are other negative factors. At such times, one must check the tract record of the company in terms of the company’s management, its creditworthiness and its financial background.
Why is a high P/E ratio dangerous?
Not all fast growing companies can sustain their high growth rates. For example, Reliance communications was trading in 2008 at 800/- and a P/E ratio of 63.84. Today its per share price is INR 60 and P/E ratio is negative*! In fact, most companies with very high P/E ratios are overvalued and are known to collapse! For this reason, the P/E ratio should not be used for high growth companies. Use the
*What does a negative PE ratio signify?
A negative PE ratio means that a company is losing money. While a negative PE ratio is bad in most situations, it is not a sure indicator. Some companies have seasonal sale cycles. For example, companies making festive decorations, lightings etc will have sales only in the festive season, but costs all round the year. So they will have a negative EPS and conversely, a negative PE ratio.
Another instance is when a company is raising money in the expectation of future returns. An R&D company needs to spend on product development in its initial days but when the product is ready and becomes successful, has the potential for huge earnings.
The bottom line, thus, is, while looking at the PE ratio, the company’s background also needs to be looked at.
Summary of the P/E ratio
Optimal Range: 10 – 30
Correlated Ratios: Company Growth Rate( sales wise & net profit wise), Price, Industry P/E ratio, PEG ratio
Advantages: 1. Good primary filter.
2. Easy to calculate.
3. Fairly accurate within its range.
Drawbacks: 1. A measure of market sentiment rather than actual valuation.
2. Fails for high growth companies.
Can not reflect the sustainability of earnings, mgt quality etc.
Check Points
1. The P/E ratio is less than 30 if growth is less than 30% pa.2. Most leading and coincident indicators show approximately the same trend as the P/E ratio.
3. The intrinsic value is not less than the stock price.
The P/E ratio in action
Below is a graph showing the price and the P/E ratio of Infosys over time. As is visible, the P/E ratio and price show the same movement! This is, of course, an ideal scenario. A lot many deviations happen when we take into account interplay between the various fundamental factors. We will discuss them gradually.Read more about the P/E ratio here:
Wikipedia
http://en.wikipedia.org/wiki/PE_ratio
Times of India
http://timesofindia.indiatimes.com/Understanding-P/E-Ratio/articleshow/24372323.cms
Investopedia
http://www.investopedia.com/terms/p/price-earningsratio.asp
About.com
http://economics.about.com/cs/finance/l/aa030503a.htm
BrainBought: The P/E Ratio: The P/E or ‘Price by Earnings per Share’ ratio is one of the most important ratios when it comes to fundamental analysis. It assesses the m...
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