P/E ratio or Price to earnings ratio is one of the most important factors to look out before investing into any particular stock. It is the simple way to determine whether a stock is undervalued or overvalued based on the entire industrial P/E. Also based on the ratio one can determine which are the best stock picks currently. The market participants and specifically the investors look after this ratio to determine their stock investments. In simpler terms, the P/E ratio is the price to earnings ratio for the companies to determine how much the investors are willing to pay for the particular stock based on its earnings and past financial performance.
Hence if a company has a high P/E it can be determined that it is overvalued or its stock price is high in comparison to its earnings. Similarly the vice versa goes for the low P/E ratio. It means a company is undervalued and its valuation is low based on the earnings of the company.
The calculation of the P/E ratio is done in the exact manner as its symbol shows. The price of the company is divided by its earnings per share. Also a high P/E not only tells that a stock is overvalued it can also mean that the investors are betting that the future of the company is better and hence they are willing to pay more price for the stock of a company regardless of its current financial performance.
The Usage of P/E ratio
Investors are keen to use the P/E ratio before picking up a stock based on multiple reasons. The high P/E suggests that the others are willing to pay a high price for the company regardless of its current earnings. This signifies that the company has a growth potential and others are betting on its future expected growth. Hence when the earnings of the company are going to rise in the upcoming years the investors also forecast that this particular company will also be willing to give dividends. Hence several factors are considered like this based on the P/E ratio.
To determine whether the stock is overvalued or undervalued based on the P/E, it is compared to the industrial average or industrial P/E ratio. It is a ratio which takes into account the companies working in the same segment and compares the P/E of all of them and takes an average based on the same for the entire industrial segment. This makes the standard checkpoint for investors to compare their company’s P/E in comparison to the industrial average and hence derive a conclusion based on the same.
This industrial average changes depending on the P/E of the companies and the market situation. For instance in case of a heavy inflation, the central bank would trigger a rate hike which directly points out that the banking stocks would be benefited with more earnings from their interest income. Hence the P/E ratio would change based on this situation.
Limitations
Apart from all the perks associated with the P/E ratio there are certain limitations to its application. The ratio cannot survive the volatility in the market. This ratio is not significant for traders or those who go after short term investment. The reason is sudden volatility in the markets based on any event in the world might make the entire P/E ratio theory baseless. The P/E ratio is based on the lost earnings and the current earnings of the company. Hence the investors are still not getting their complete information of the further changes in stock prices. Hence this ratio is accompanied with another ratio known as PEG ratio to set off this limitation.
PEG Ratio
It is a ratio which takes into account the P/E ratio and the expected growth of an industry or company by the analysts which then becomes the future insight of the company. For instance if a company has a P/E ratio of 30 and the projected growth for the same is 20% in the upcoming 5 years then the PEG ratio will be 30/20 = 1.5. This is then compared to the average PEG forecast for the standard index which in India can be Sensex, Nifty or Bank Nifty or other Nifty subsidiaries. Through this one can get a comparison of the growth forecast of the entire market index and the growth forecast of his particular company side by side. This makes the decision making even better as the entire calculation is based on past earnings, current results and the further projections.
Despite all such factors one needs to observe the current market trends and the future growth of a particular industrial segment based on the analysts’ predictions. This would assist in modifying the research base of companies in the watchlist and the investments made as well. Also the ratios are mere calculations to add up to the entire analysis of a particular company. Hence it is just a factor to ensure the perfect pick for a market participant.
