What is Price Earning Ratio or PE?
PE ratio is the easiest way to value a company. Numerically it is defined as
PE Ratio = Stock Price / EPS.
Here EPS is earning per share which is reported by every company along with quarterly results. Normally we do not calculate PE of a Company. Most of the websites report this ratio along with Stock ticker. So you can take the ratio value from any of the website which you prefer.
- For example Stock Price is 100
- EPS for company is 10
- PE ratio = 100 / 10 = 10
- If stock price is 500
- PE ratio = 500 / 10 = 50
Now the value of ratio will increase of decrease per day depending upon the stock price movement. This is important to understand. The EPS of company is reported Quarterly so the denominator of above equation will be fixed for certain period of time. But the numerator of the above equation will change on daily basis. So the ratio is directly proportional with stock price. If the stock price moves up then the ratio will move up and if the stock price will move down then the ratio will move down.
How PE ratio determines Valuation?
Above we understood that ratio value increases if stock price increases and it decreases if stock price decreases. Now the denominator EPS is earning per share. The numerator is the price of 1 share you are willing to buy for. Ideally what 1 share is earning the same price you should be paying to buy it. In that scenario you are not giving any extra money then what stock is earning and you are not gaining anything extra as well.
Now Stock prices depend on perception of people about Future performance of that stock. If people think that company will perform better than what it is now then they will spent more money to buy it. If they are willing to spent more than numerator is increasing causing the PE to be more making it costly. You can think of it as parcel of land if you think land will be more valuable in future then you will buy even if price is higher. The same goes for stock as well.
The more PE a stock commands the more costly it is. So if the performance of the company in any one quarter is less then denominator will decrease making the PE even greater at same stock price. Now people will think it to be costly as PE will become very high. So they will bring down the stock price and consequently ratio will also come down causing valuation decline.
What is ideal PE for a stock?
People often ask how to determine valuation of a stock. What is the ideal PE ratio for a stock? The simple answer to this question is there is no such value as ideal value. Period. Everything is relative in market. Something is costly or cheap is determined by the price of similar instruments or historical value of the instrument itself.
People often make mistake of comparing two different entities and come up with conclusion. For example you should not compare a Banking sector stock with FMCG sector stock and conclude one is cheaper than other. These two are different sector stocks and should be compared with same sector stock to determine if it is cheap or costly. Similarly Index PE should be compared with Index not stock to determine if it is oversold or overbought.
These is very fundamental mistake most people I have seen do. They compare stocks from different sector. One more thing you can do is to compare the stock current ratio with historical value of it. This also gives you fair idea of valuation it has commanded over a period of time.So if I have to conclude the valuation of stock or ideal value of the ratio for stock then
- Compare stock price earning ratio with same sector stocks
- Compare stock price earning ratio with its own historical value
Is buying Low PE stock value investment?
This is very common misconception people have. As mentioned above PE ratio is one of the easiest way to determine stock valuation. People often get carried away thinking if a stock has low PE then it is at very cheap valuation so we can safely invest in it. The statement should be If a stock is trading at lower valuation compared to its peers and its historical ratio then it can be thought of a low valuation stock and is cheap.
After establishing valuation of stock as mentioned above one should ask simple question like Why the market is giving low valuation to this stock? As discussed stock price is perception about future growth of company. Why market has perception that stock will have low valuation going forward.
If this question is answered and you are satisfied by the reason of low valuation then you can think of it as value investment or value buy. Simply seeing stock price earning ratio should not be reason of buying the stock. So lets recap what we discussed
- Is current PE lower than historical value?
- Is current PE lower then peers in same industry?
- What is reason of low PE ratio?
Answer to these three questions will help you know if you are investing in value stock or not. People without researching enough and investing in cheap stocks if not making money say value investing does not work anymore now.
Should I invest in high PE stock?
It is yet another misconception promoted by people favoring Momentum investing and Growth investing. They cite some stocks and say look that stock was not cheap few years back and is not cheap now. People have made money in these stocks. So high price earning ratio stocks are not bad. You can invest in them as these are growth stocks. But they forget to mention dozens of stocks which caused melt down in market if results were not in line with high ratio value they commanded.
High PE ratio stocks should have their EPS increasing else the ratio value will increase. If the denominator does not increase for some quarters then stock price will come crashing down causing huge loss to investors. The safety cushion is low for high price earning ratio stocks. So you should closely observe the results of companies and see if the perception about growth for the stocks are met with each quarter. If there is change in perception then loss will widen for investors. Below are key points you need to consider before investing in high price earning ratio stocks
- Is high value backed by performance?
- Is the value inline with other industry peers?
Should you invest based on PE only?
Based on the discussion above about value investment and growth investment you should have known that only PE ratio based investment is not sufficient. You should not consider investing only looking at value of this sole indicator. There are many other parameters you should consider along with this one. This is the easiest indicator which is mostly used for quick check to determine stock valuation.
This can be filter condition for you to eliminate stocks from our investment list. This should not be parameter to determine if stock can be invested into. Hope this statement clarifies the difference or approach you should follow while using this parameter.
Conclusion
In case you have any further questions or wants to know more about this topic then you can ask me on Telegram. The channel has chat enabled so you can ask your questions and get response.There is also provision to post your questions on other social media channels of my website. I will try to answer them there but preferred one is Telegram as mentioned above as it is easy for me to monitor it.