Using the Price-to-Earnings Ratio to Assess a Stock: Guideline with examples

 Using the Price-to-Earnings Ratio to Assess a Stock: Guideline with examples

For investing in the stock market for long term investment one should carry out the fundamental analysis by yourself of the stock before investing in any stock. You should not rely on the tips and recommendations from the broker or anybody.

There are many ratios that are being calculated to make better decisions for investment into a particular stock. So, to carry out the fundamental analysis the P/E is the first ratio to be calculated but for that, you should know certain terms.

The P/E ratio which represents the valuation of the stock and gives us the direction for proceeding the decision. But before directly going for the P/E ratio first let us understand the EPS which is required to calculate the P/E ratio.

What is EPS?

EPS is nothing but the earning per share means the income return from a single share.

It is defined as the company’s net profit divided by the number of shares

 EPS =   Net profit/No of Common Shares             

The net profit is calculated after deduction of taxes (Profit after Tax –PAT)

For example, if a company let us say ABC incurred profit after-tax is 100000 and having a number of shares in the market is 10000 then its EPS will be 100000/10000 = 10.  

This 10 represents the income per share for that year.

To carry out the fundamental analysis one should consider the EPS value for last consecutive 5 years this will represent the direction of the growth /loss of the company.

A higher EPS gives the direction that more value and people will attract towards investment because they will think that this is a profit-making the company, and people will get confidence to invest in that company

EPS helps in financial statement analysis and calculations.

PE Ratio:

Before investing in any stock one should know that the stock price is overvalued or undervalued. For example, if you have a choice of two residential property in which you would like to invest suppose one property is having the value of 25 lakhs and it gives 10000 (ten thousand) rent and another property is of 30 lakhs and it gives rent of 15000/- then where you will invest, naturally one will decide to invest in 30 lakh property though investment is slightly high but it gives 50% higher returns from the other property. The same fundamentals are applicable in stock also.

P/E = Price per share/EPS.

Here price per share means the market value of the share.

Let us say one company whose current market share value is 200/- and its EPS is 10 then P/E will be 20.

What this PE ratio indicates?

This 20 indicates that for getting One rupee income from this company’s share one has to pay 20 times more amount. i.e. One should have to pay 20 rupees to get the income of one rupee from this stock.

Why PE ratio is important?

1.       Stock Valuations

2.       Is the stock overvalued or undervalued?

3.       It also gives idea for entry or exit from the stock.

4.       Comparison of a company with the sector.

5.       Financial analysis with different ratios.

Let us understand by Example.

Company ABC			Company XYZ
I IEPS	10		EPS	20
Price	100		Price	400
P/E ratio	=100/10 = 10.		P/E ratio	=400/20 = 20.

 

And Sector P/E =18

In the above example company ABC stock is cheap and Company XYZ stock price is slightly expensive. This is because the sector PE is 18 In this case low PE doesn’t mean that company’s share is a recommendation to buy or Company XYZ is not to the recommendation to buy some times expensive share can be bought how?

Let us understand by the following example.

Company ABC

	Year-1	Year-2	Year-3
EPS	10	11	12	·         company EPS is growing by 10%
Price	100	110	120	·         Price is also growing @ 10%
P/E ratio	10	10	10	·         P/E ratio maintained at 10.

 

Company XYZ

	Year-1	Year-2	Year-3
EPS	10	20	40	·         Growth is doubling here
Price	100	400	1600	·         Price is also increasing with a high margin
P/E ratio	10	20	40	·         P/E ratio also getting doubled.

 

In the above example what would be the decision to buy?

·         Company ABC P/E low but growth is also low. It is growing @ 10%

·         Company XYZ P/E ratio high and growth is also high it is growing @ 100%

Conclusion:

Company XYZ has a better future the prospectus and it has high potential to grow hence it will be beneficial to buy the XYZ company stock.

Company ABC is slow-growing company and hence has no potential to grow further.

Another example of a low PE ratio. ( Negative growth)

	Year-1	Year-2	Year-3
EPS	80	60	40	·         company EPS is declining
Price	2400	1200	400	·         Price is also declining
P/E ratio	30	20	10	·         P/E ratio declining

 

In the above example, PE is low and also growth is negative. So it is not advisable to buy the stock.

 

	Year-1	Year-2	Year-3
EPS	10	25	50	·         company EPS is growing fast
Price	100	375	1000	·         Price is also increasing
P/E ratio	10	15	20	·         P/E ratio not increasing as per growth

 

In the above example company growth is high as well as EPS is also high but P/E ratio is not increasing that fast that P/E ratio is moderate. This may happen in cyclical Industry for example in construction Industry it may have a high business in tow years but in subsequent years it may not do that much business. In this case, the P/E ratio will increase as expected.

So PE is dependent on so many factors like the type of Industry, so before investing in any stock  and always identify the reasons for the PE ratio. Generally

Low P/E

1)      Low P/E is for an undervalued stock

2)      Low growth or negative growth

3)      Future prospects are not great

High P/E

1.       Stock is overvalued

2.       High growth

3.       Great future prospectus.

How to check the P/E ratio the right way?

·         Always compare stock with competitive  Industry and industry average PE

·         Do not compare different companies PE to buy or sell for example Software Company should compare with the software industry and not with the Auto or Metal sector industry.

·         Why P/E is high or low

·         Growth is sustainable or temporary

Always Remember:

·         Low PE means not to buy

·         High PE means not to sell

·         Always compare PE with other companies of the same sector

·         Do not compare different companies PE to buy or sell

·         Always compare stock with competitive  Industry and industry average PE

 

There are two types of PE

1.       Trailing PE: On some websites, it is written near the P/E ratio as TPM means trailing per month. It is derived from historical data. It is a more authentic value as it is based on historical data.

2.       Forward PE: It is estimated data. It is not much authentic value, it is an estimated value.

Market PE:

There is also market PE like NIFTY PE it can get you in any website. As per statistical data, the market PE is on an average remains around 18

The economic survey related the market PE as if the nifty is more than 21 then it is overvalued and if it is below 16 then it is undervalued.

It indicates that if the nifty PE is more than 21 then the prices of nifty stock have moved a lot faster as compared to the earnings of the nifty company. Historically it has shown that if the market PE goes higher than one above 18 then it gets corrected.