How to interpret P/E Ratio?

First let’s understand the concept of PE ratio in simpler terms.

Imagine you go to Big Bazar and buy a shirt in bargain for INR 300/-. Happily when you come out of it, you met a friend who too co-incidentally bought the exact same T-shirt from DMART but for INR 200/-. Ops! How do you feel now? You ended up paying more and now that happiness fades away. Right?

The exact same thing happens when you pay more for a particular investment and that is where PE ratio comes into play. Honestly, every one wishes to buy low and sell high, but strangely only a few people are able to do so. This is where PE ratio can help you.

The price-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings.Statistically we can derive the formula by saying that P/E ratio is =

Stock Price/Earnings per share

For an instance= If SBI share price is INR 330 and it’s earning per share is 13.15 then it’s PE ratio is = 25.09 at the moment.

Now, coming back to the question, how can this PE ratio help you in evaluating if a particular share is right for investing or not. So, lets understand why is it important to look into the PE ratio and what story it tells. I am sure by the time you are done with these points, you will have fair knowledge about how P/E ratios can serve the purpose of systematic investments-

1. Understanding PE gives the investors an idea if the stock has sufficient growth potential.
2. Generally a high PE ratio suggests that market participants are bullish on the stock and expect the company to post higher earnings growth going forward. However, it can also be interpreted as an overpriced stock in some cases.
3. On the face of it, it would seem that companies with low P/E ratios would offer the most attractive investment opportunities. This is not always true. Companies with high current earnings but dim future prospects often have low P/E ratios.
4. Stocks with low PE can be considered good bargains as their growth potential is still unknown to the market.
5. Abnormally high P/E ratios, combined with exuberant headlines, can be a signal that the market is overheated and equity exposure should be reduced. Abnormally low P/E ratios, combined with pessimistic headlines, can be a signal that equity prices could be "on sale.
6. As an investor your primary concern is with the future prospects of a company and not so much with its present performance. This is the main reason why companies with low current earnings but bright future prospects usually command high P/E ratios.
7. You need to consider a few more factors before evaluating a company on the basis of PE ratios, primarily Human resource, Brand , Capital and competition as these will affect the earnings in future and P/E ratios derive their values from earnings.
8. Interpretation of PE ratio is heavily dependent on comparison of the company with its peers. Also PE that is considered very high in certain sectors can be considered very low in other sectors.For instance, companies in IT and telecom sectors have higher PE ratio than the companies in manufacturing or textile sectors.
9. P/E ratio has to be used with our assessment of the future earnings and growth prospects of a company. You have to judge the extent to which its P/E ratio reflects the company's future prospects.If it is low compared to the future prospects of a company, then the company's shares are good for investment. Therefore, even if you come across a company with a high P/E ratio of 25 or 30 don't summarily reject it because even this level of P/E ratio may actually be low if the company is poised for meteoric future growth. On the other hand, a low P/E ratio of 4 or 5 may actually be high if your assessment of the company's future indicates sharply declining sales and large losses.
10. Traditionally there are certain sectors like diamonds, fertilizers or sectors that are very cyclical and command a low PE ratio. There are certain sectors like FMCG, Pharma, IT that normally have a higher PE. So the PE ratio of a company should either be compared with its peers having parallel business activity and of similar size or with its historical PE to evaluate whether a stock is undervalued or overvalued.

I hope now you have a fair understanding of what PE ratio is.

-Abhishek Kar

MD AKTG Capital Management