Almost everyone who has dabbled in the stock market must have heard about P/E once , so what is P/E ratio ? P/E ratio is used to determine whether a companies stock is cheap or costly , in fundamental analysis the main aim is to find whether a stock is cheap and has potential to further rise this is different from technical analysis as in technical analysis no stock is cheap or costly , both are different branches of analysis in stock market help in understanding the value in a stock.
What is P/E ?
P/E is the ratio of the price and EPS , where EPS is the earning per share which you can get simply by dividing the earnings by the number of shares floated by a company.
EPS = Earnings / Total number of shares
Total number of shares can be got by dividing the market capitalization of any company by the price of its share for example if the market cap of any company is 100 and total number of shares floated by the company is also 100 then EPS is 100 divided by 100 that is 1 . Learn more about Market capitalization – here .
P/E = Price of Share / Earning per Share (EPS)
Then you can simply get the P/E by dividing the share price of any company by the EPS , for example in the above example we got EPS=1 and assuming price of share is 20 so P/E will be 20 divided by 1 that is P/E = 20 .Thankfully you don’t need to calculate the P/E yourself , P/E is available for any stock online on websites like moneycontrol etc.
How to Compare the P/E correctly ?
So one thing must be understood that you cannot compare the P/E of a company of one sector to a company from another sector , if you are comparing P/E of Infosys (IT sector) to CIPLA (Pharmaceutical ) then that is not how it works , different sectors have different revenue models and cash flow along with different structure of the organizations all of which affects the revenue overall , its just like comparing apple to oranges , so what should you do ? You should compare the P/E of a company to company in the same sector or the sectors combined average P/E to get an idea of the worth of the stock.
Low P/E means stock is cheap and high P/E means stock is costly ? NO !
No low P/E doesn’t always necessarily believe that stock is cheap and high P/E also doesn’t always mean that the stock is costly , if it was this simple then anyone would simply compare the P/E and make investing decisions within a minute and would become a millionaire in few years .
So when will a companies P/E will be low ? it will be low when earnings or earning per share is more and price of the stock price is low , but assume that a companies earning is somewhat stagnant and the share price is also not moving much that also does make that companies P/E low as compared to its industry average P/E , so would you buy the share of a company with stagnant and low P/E ? A company with stagnant income and price of its stock being range bound indicates that investors simply aren’t interested in the company .
Similarly a stock with high P/E doesn’t always means that the stock is costly as per fundamental analysis , it can also mean that investors are simply very enthusiastic about the company and want to buy it at even higher price hence the stock is soaring is higher , coupled with good income increase YOY ( Year on Year ) such high P/E also can be justified easily hence buying a high P/E stock doesn’t always means stock is costly.
So P/E ratio is of any use or not ?
P/E ratio is of use and can be used in combination with other fundamental analysis elements , for example there is a stock X which is increasing it’s earning by 10-15 % YOY basis hence is performing very well also its management is very experienced and hasn’t pledged any shares and the company is debt free etc , but the price of the share isn’t increasing with such pace thus making it’s P/E low as compared to its industrial average P/E , this is what a fundamental analyst is after , these are the stocks that have huge potential and can become multibagger .Similarly imagine a company with a high P/E which has a stagnant or decreasing income in recent quarters but the price of its stock hasn’t reflected this fundamental change and stock price hasn’t dropped much , this is what makes a stocks price little costly and such stocks should be avoided for investment purpose.
Summary –
So we have learned two very important facts related to the P/E ratio that you cant compare a stocks P/E to another stock in different industry and low P/E doesn’t always mean that stock is cheaper it can be a stagnant income company having low to none bullish investor sentiment , similarly high P/E also doesn’t always mean that stock is costly it can be also a stock having good income increase YOY basis and with high bullish investor sentiment , P/E shouldn’t be used in isolation it should be coupled with balance sheet analysis , cash flow analysis other financial ratio analysis like ICR , DSCR , analysis of credibility of management and other fundamental analysis points.