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Decoding P/E Ratio: How It Helps To Identify Great Investments?

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How can you identify the best stocks at bargain valuations? How can you identify if the current stock price justifies the company’s earnings prospects? In such cases, P/E Ratio can be the answer.

Introduction To P/E Ratio

The Price Earnings Ratio (also known as price multiple or earnings multiple) is one of the most widely used tools to value a company and spot the best stocks to buy. It measures its current market share price of the stock relative to its earnings per share. It tells you how much you’re paying for each rupee of the company’s earnings.

It can be calculated as Market price per share / Earnings per share.

What Does It Indicate?

To get a better picture, one should compare the P/E multiple with the prevailing industry standards.

A high P/E ratio indicates:

  • A stock is overvalued and that the investors are anticipating a higher growth rate in the future, which leads to frenzied buying of stocks in euphoria. This can shoot-up the market prices of a stock, and thus swell the P/E multiple.
  • A high P/E ratio can be justified in times of expansionary stage of a company, which may eat up the company’s earnings, thus shrinking the P/E multiple.

A low P/E ratio indicates:

  • The company is currently undervalued or that it is expanding at a very rapid rate before investors could notice its accelerating growth rate.
  • It may also mean that the investors are losing confidence in the company’s potential, thus driving the stock price and P/E multiple downwards.

Please note: When a company has no earnings or is reporting losses, the P/E multiple would be expressed as ‘N/A’.

Caution Points While Using P/E Ratio

Though it is one of the most used tools by analysts to benchmark and give stock advice, it is recommended not to rely heavily on PE ratio while investing in stocks. Few aspects need to be considered before zeroing down on the stocks to invest in.

  • It is not a single metric to guide you in your investment decision. Instead, it should be used as a complementary tool with financial leverage, expenses, dividend yield, turnover, etc.
  • The debt levels can affect a company’s earnings and market price, which implies that they can skew PE multiple as well. If there are two companies ‘A’ and ‘B’, and if company A has more debt than company B, then company A will display a lower PE than company B.
  • It is recommended to use this comparison tool only while shortlisting companies operating within the same sector. For example, IT and telecom companies may exhibit a higher PE as compared to the companies in the manufacturing sector.
  • In few industries such as Financial Services, Cement Industry, etc., other valuation approaches are considered to be more pertinent.
  • P/E numbers may not be suitable to value companies in an industry with high entry barriers. Say, for example TV18 Broadcast Ltd, where the P/E ratio is toggling in a range of 95-98, one may think it is overvalued on a prima facie. However, it is an ace player in a TV industry which has high barriers to entry.
  • The accuracy of the PE ratio is dependent on the exactness of its inputs such as EPS and MPS. While the market prices are easily available, the same is not the case for earnings which is reported by the companies themselves. In few cases, companies may manipulate the data to skew the price-earnings multiple.
  • While calculating the forward-looking P/E ratio, one may use past EPS to forecast the future performance. Now, there is no guarantee that the company will continue to experience the same growth trajectory on account of a change in macro variables, sector-specific trends, change in regulation, etc.

Concluding Note

It is very important to perform a due diligence of the company and dig more into the credibility of the management, growth plans, cost of capital, bottom-line and top-line indicators, the strength of balance sheet, etc. before investing in a stock.

Read more:  How Long-term investing helps create life-changing wealth – TOI

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