What is P/E ratio???
Can it help me in valuing or knowing the true (Intrinsic Value) value of the stocks I am holding???
Well, that’s true to certain extent. PE ratio of a particular stock is much useful in finding whether the stock I am holding or planning to add to my current portfolio of stocks is worth the price I am paying for it.
Formula of PE ratio :
PE ratio of Stock X = Market Price of the Stock X/Earning per share of the Stock X
How to interpret PE ratio of a stock??
Suppose Mr X wants to interpret or understand the meaning of PE ratio of TITAN Company [this is the stock which made more than Rs 4000 crores(approx figure) for Mr Rakesh Jhunjuhunwala] Stock
I am taking Standalone (Means excluding the data of subsidiaries of TITAN Company) figures out here.
Here EPS is Rs. 15.48 and Market price of the share is Rs. 1,091.05, so accordingly PE ratio be 1091.05/15.48=70.48 . This PE ratio or commonly also known as PE multiple shows that investors are ready to pay Rs.70 for each rupee of profits company earns.
Please note that EPS=Profits earned by company/No of shares of the company
Now take another example of Rajesh Exports(A peer group company of Titan)
It’s PE ratio would work out to be 685.35/15=45(Approximately). It shows that Investors are ready to pay Rs 45 for each rupee of profits earned by Rajesh Exports.
Your next question would be why People are ready to pay Rs. 70 for TITAN and Rs 45 for Rajesh Exports. It is mainly due to the investors expectations about the future earnings and growth in those earnings of the company.
People are more optimistic about future of Titan’s earnings as compare to the earnings of Rajesh Exports.
Can PE RATIO help me in finding the valuation of a stock ?????
Yes, it can..
Now talking with a generalistic view, stocks above 50 PE ratio can be considered as overvalued and below that can be identified as undervalued securities.
But if the size of business opportunity for a company is big then it is advisable to buy that share even though it is trading above 50 PE.
Like TITAN Company was is now trading at 70 PE, so if an investor would have invested in that share at 50 PE even then he would have made mind blowing gains in it also i.e around 40% appreciation, and this is purely due to the size of business opportunity existing for TITAN at 50 PE ratio even.
Note: there is no perfect value of PE parameter around which we can determine the exact valuation of a company’s share.
What is Forward Price-To-Earnings
These two types P/E ratios: the Forward P/E and the trailing P/E.
The forward (or leading) P/E uses future earnings expectations. It helps provide a clearer picture of what earnings of the company will look like.
Predicting forward P/E requires estimating the expected earnings per share , which in itself is subject matter of judgement on the part of Investors and it can vary substantially from person to person.
When trying to figure out whether a company’s price, and its forward P/E ratio, are “fair,” an investor should try to figure out what assumptions have been made regarding the company’s fundamentals.
The trailing P/E relies on past EPS of the company and is derived by dividing the current share price by the EPS over the previous 12 months.
Some investors prefer to look at the trailing P/E because there is lack of objectivity in another individuals earnings predictions.
But Trailing P/E suffers from a major drawback and is the earnings of company(EPS) can not be expected to grow at the historical growth rates of company’s profits.
Specifically in the case of cyclical industries or commodity based companies whose profits can not be predicted with assurance, trailing PEs can not be used for valuation of shares.
LIMITATIONS OF THE PE RATIO
A. Comparability: One should only use P/E as a comparative tool when considering different companies in same sector. P/E can not be used to compare companies working in altogether different sectors. Like we can not compare PE multiple of Infosys and TATA steel as one is an IT company and other one is in steel sector.
B. Considering P/E solely: Rather than treating the P/E ratio as a derivative of the fundamental characteristics like EPS, Growth rate, Return on Equity(ROE) that drive the intrinsic value of a share, they treat it as a characteristic unto itself, capable of being evaluated on its own terms.
For example, you might hear someone say that a stock is trading below its 20-year average P/E, and that therefore it is cheap. Or they might compare one stock’s P/E to another; for example, “This stock has historically traded at a 20% higher P/E than that stock, but today it is trading at a 30% higher multiple, so it is expensive.” These sorts of statement implicitly assume that P/E ratios have a kind of life of their own.
But this kind of thinking is ultimately just a way to avoid the harder work of understanding whether something has changed at the company, specifically whether there have been changes in the fundamentals(like EPS, EBIT, SALES, COSTS, DEBT) that drive the stock price.
While understanding P/E ratios it seems pertinent to mention PEG ratios also.
PEG ratio= P/E ratio/ Growth rate
Now there is a fraction of analysts who feel that P/E ratio does not consider growth rates(provided the share has been valued ignoring growth rates in earnings of share) while finding whether the share is under or over valued actually.
So PEG ratio is the one which removes this inherent drawback of using P/E ratio and gives us a better estimate of value of the share.
Generally a share available at 1 or 1.5 PEG is considered a good investment and above that shares are reckoned as expensive or overvalued.