This is just an introduction about price earning ratio (PE). Beginners can gain some insight about PE in this blog post.

It is not useful to compare market price of one stock with another.

But use of suitable ‘ratios’ makes this comparison effective.

One of the best ratio that is most widely used for stock’s market price evaluation is the price earning ratio (P/E).

Using this tool we can compare stock of different sectors.

Even stocks, having different numbers of shares outstanding in market can be compared using P/E ratio.

Though the price earning ratio (P/E) also has its own limitations but the ‘ease of its use’ is unquestionable.

Probably this is the reason why, starting from novice to experts, all use P/E ratio to value stocks.

We often come across many financial ratios particularly when it comes to stock investing.

Out of all ratios that I come across regularly, the price earning ratio (P/E) looks like simplest of all.

But this is where I would like to draw your *caution*.

Understanding P/E ratio is simple, but its interpretation is tricky. Why it is so?

To understand this, we will have to see the price earning ratio (P/E) with a perspective.

Suppose we have two stocks (A & B) whose earning per share (EPS) is same, $5/share.

Generally speaking, stocks with same EPS should also have the same P/E ratio.

But this is not the case in real world.

For the same EPS levels, different stocks have different P/E ratio.

This means that some stocks trade at a higher market price for the same EPS levels.

Why this disparity exists?

Frankly speaking, this is not a disparity at all.

This difference originates quite naturally between two different companies.

#### Example-1:

Two stock (A & B) having the same EPS of $5.

And the same market price of say $10/share.

It means both has the same P/E ratio of 2.

Stock A represents a company which is run by a marvellous management.

In last 10 years, EPS of stock A has risen from $1 level to $5 (@17.5% per annum).

Stock B represents a company which is run by an average management.

In last 10 years, EPS of stock B has risen from $3 level to $5 (@5.0% per annum).

Out of stock A & B, for which, the investors are more likely to pay higher price to buy its shares?

The factor of marvellous management and high **EPS growth** makes stock A more likeable over stock B.

Hence investors may pay a higher price to buy stock A compared to stock B.

Though Stock A and Stock B has the same P/E ratio at the moment, but looking only at P/E ratio does not say which stock is good for future buying.

Here I will suggest my readers to use the P/E with caution.

It should not be given over importance.

#### Example-2:

Two stock (A & B) having the same EPS of $5.

But their market price is $10/share and $8/share respectively.

As stock A has higher P/E for the same EPS levels, investor might think that stock A is overvalued compared to stock B.

But this conclusion may be erroneous.

It may be possible that Stock A deserves to get a premium due to its strong future growth prospects.

This is the reason why one should not consider P/E as the ultimate test.

In the process of price valuation of stocks, P/E ratio can be a good point to start.

But other checks to confirm the findings of P/E ratio is essential.

## #1. About price earning ratio (P/E)

To calculate the price earning ratio (P/E) divide the current market price of a stock with its earning per share (EPS).

Generally you will see the price earning ratio notified in stock quotes as P/E (TTM).

What it means by TTM?

P/E quote published on internet for stocks, in general, is for trailing twelve months (TTM).

Means, the reported quarterly EPS of last 4 quarters is used to calculate current P/E ratio.

#### #1.1 How best to use the price earning ratio (P/E)?

Stocks of the same sector must be compared with each other.

One can also compare a stocks P/E ratio with its industry P/E.

**Lets take an example:** We have three stocks of the same sector A, B & C. Industry P/E of this sector is suppose 17.

P/E ratio of individual stocks is A=10, B=8, C=21.

How to draw some conclusion out of this data?

Compared to industry P/E ratio of 17, A and B is undervalued.

But C is overvalued. Compared to A & C, stock B looks undervalued.

Compared to Industry, stock A&B, C looks most overvalued.

People who deal with stock price valuation in more depths, calculated even deeper P/E ratio (deeper than just TTM).

I personally collect quarterly earnings of last 10-15 years.

This data I used to calculate average price earning for of last 5 years, 10 years and 15 years.

I maintain an excel sheet where I record P/E (TTM), P/E (5Y), P/E (10Y), & P/E (15Y) of the stocks in my watch list.

This gives an excellent idea of potential future price growth that a stock can promise.

A typical data is provided herewith

P/E (TTM) | P/E (5Y) | P/E (10Y) | P/E (15Y) |

28 | 27 | 22 | 11 |

Looking at this data it looks like this stock has potential to give great future return wherein their P/E itself may grow @ of 6.4% per annum.

It will also be interesting to check the P/E of SENSEX and NIFTY for the same time horizons.

Comparing P/E ratio of stock index with P/E ratio of individual stock will also give an idea of whether stock price is over performing and underperforming.

P/E (TTM) | P/E (5Y) | P/E (10Y) | P/E (15Y) | Stock |

28 | 27 | 22 | 11 | |

P/E (TTM) | P/E (5Y) | P/E (10Y) | P/E (15Y) | Sensex |

22.67 | 17.38 | 15.66 | 16.18 |

From above table it is clear that Sensex has increased its P/E ratio at rate of 2.27% in last 15 years.

Compare this with growth of P/E of individual stock @ 6.4% per annum.

#### #1.2 Forward P/E and P/E (TTM):

It is also a good idea to compare P/E (TTM) with Forward P/E.

Forward P/E ratio is calculated using estimated EPS for next 12 months in future.

This estimation of forward P/E is based on forecast that companies often report in their financial reports.

For example, Hindustan Zinc is currently trading at P/E (TTM) of 12.4.

But its forward P/E is quoted as 12.2. It means that market is estimating an increase in companies EPS in next twelve months.

Hence, it can be said that comparing P/E (TTM) with its own forward P/E provides a more reliable conclusion.

#### #1.3 PEG Ratio:

In addition to forward P/E ratio, there is another metric which gives more reliability to P/E (TTM).

This metric is Price earning growth ratio (PEG). In my blog,

I have explained the **utility of PEG ratio**.

PEG is calculated by dividing PE by EPS growth rate.

In terms of price valuation of stocks, the lower is the PEG the better.

Lets see an example to understand how we can use PEG ratio to compare two stocks.

Suppose we have two stocks named A & B. P/E ratio of A & B is 16 and 22 respectively.

Looking only at P/E ratio it seems that A is undervalued compared to B.

But now lets factor in the parameter of EPS growth rate.

Suppose EPS growth rate (TTM) of stock A is 8% per annum and that of B is 12% per annum.

Using these EPS growth rates, lets calculate the PEG. For stock A, PEG will be 16/8=2. For stock B, PEG will be 22/12=1.83.

See how the conclusion has changed after we have imposed the factor of EPS growth on P/E ratio. PEG of B is only 1.83. PEG of A is 2.

The lower is the PEG ratio the better is the stock’s market price valuation.

So, looking also at **PEG ratio** it seems that B is undervalued compared to A.

I personally use both P/E and PEG ratio in conjunction before making any impression about the stock’s price valuation.

## #2. Interpretation of the Price Earning Ratio

What does the price earning ratio of a stock tells about it?

To understand this, lets see again how P/E ratio is calculated.

Price divided by EPS. Earning per share is companies net profit divided number of shares outstanding.

So in a way we can say that P/E ratio is companies market price divided by companies profits.

So now, lets see how this ratio can be interpreted by a common man like you and me.

Suppose we are dealing with a stock whose P/E ratio is 16.

Here, the sixteen means that an investor is willing to pay $16 for every dollar of profit generated by the company.

Suppose the above company made a profit if $100,000 (EPS=$2) in FY 17-18. P/E of 16 means, investors are willing to pay $1,600,000 (Price=$32) to buy the company (each stock).

As already explained before, P/E ratio is like a primary check of **how the company is valued** compared to its **net profits**.

But it does not factor-in the future growth prospects of the company.

But till now we have seen P/E ratio with reference to only EPS (net profit per share).

But there is also another very important metric which forms P/E ratio. It is market price of stock.

There are supporters of traditional P/E ratio, who say that future growth is already factored in the price earning ratio.

Hence it is not necessary to estimate forward P/E and PEG ratio to certify the values of P/E ratio.

Supporters of **Efficient Market Hypothesis (EMH)**, say that market price of a stock has built in itself “*everything*“.

Stock price, at any moment of time, already represents all positive and negative expectations about the future performance of the company.

The belief is like this, “Mr.Market knows it all”, and it is impossible to outperform it.

Hence any corrections in P/E is an unnecessary exercise.

This is one way of looking at P/E ratio. But I personally feel more solace in keeping controls in my hands.

*Giving equal importance to P/E (TTM), forward P/E and PEG makes me more comfortable*.

## #3. Growth stock’s Vs Blue chip stock’s P/E ratio

Companies which shows robust future growth prospects will have higher P/E ratio compared to similar company showing dismal growth.

So does it mean that all stocks showing high P/E ratio are good for purchase and low P/E stocks are bad-purchase?

No this conclusion is too simplistic.

We cannot see the price to earning ratio only from the angle of growth.

Apart from sales/profit growth, there is another metric which is even more important for a business.

*It is stability and predictability of future earnings*.

It is not easy for a business to reach a stage where its profits/sales are almost predictable.

No matter what, such business are sure to get a certain level of sales/profit each year in future.

In our common terms we call such companies as **Blue Chip Stocks**.

These represent such companies which has already matured.

Blue chip stocks may not promise high future growth, but their earnings are very assured.

In general, fast growing stock will carry higher P/E ratio.

Matured, blue chip stock will carry lower P/E ratio (compared to growth stocks).

But does this mean that all blue chip stocks are undervalued? Not at all.

One must not compare P/E ratio of a growth stocks and blue chip stocks.

This is one understanding which is very essential while utilizing P/E ratio and drawing conclusions out of it.

While comparing P/E of different stocks, it is important to understand if a stock is a growth stock or it is a matured company of its sector.

## #4. Looking at the P/E ratio and not at price alone

Comparing market price of two stocks means nothing. But compareing the price earning ratio (P/E) of two stocks makes more sense.

Why it is so?

Lets take a simple example. Suppose there are two stocks A & B.

Both these stocks are trading in market at market price of $50 per share. Whom to choose for buying?

Though there are several parameters one much check before buying A or B, but I will ‘first’ look at their P/E ratio.

Stocks A trading at $50, having P/E ratio of 12 is a better stock than Stock B trading at $50 but having P/E ratio of 15.

But as it is not advisable to pick stocks by looking only at in market price, it is also not advisable to rest once case after checking P/E ratio.

I personally check P/E & PEG ratio to make my impression.

A stock which is showing EPS growth of only 4.46% per annum and carrying a P/E ratio of 42.8 is not justifiable.

This stock is too overvalued.

Company Name | Net Sales (Rs. cr) | EPS Growth (5Y) | P/E Ratio | PEG | Remarks |

Cipla | 12,034.06 | 4.46% | 42.8 | 9.60 | Not justifiable |

Lupin | 11,280.07 | 28.89% | 20.93 | 0.72 | Looks Good |

Dr Reddys Labs | 10,207.70 | 8.09% | 34.62 | 4.28 | Not justifiable |

Glenmark Pharma | 6,113.50 | 39.76% | 16.18 | 0.41 | Looks Good |

In order to value stocks using P/E ratio it is also essential to compares stocks of same sector.

Like I have prepared a table above. Here you will see that only pharma stocks has been used for comparison with each other.

## #5. The Limitations of P/E ratio

Based on what we have discussed till now about the price earning ratio (P/E), we could understand that P/E ratio has its own limitations.

Every stock’s P/E cannot confirm if its market price is overvalued or undervalued.

So what makes the utility of P/E so limited?

The market price of a stock (P) is something which is fully transparent.

In normal circumstances, it is not easy to manipulate market price.

So from point of view of market pricing, P/E cannot pose a limitation.

But the other stock metric (E) is something which poses a major threat to the acceptability of P/E ratio.

“E” is earning per share. This is calculated by dividing net profit for company (PAT) by number of shares outstanding.

As far as number of shares outstanding is concerned it is ok as that also cannot be manipulated. But PAT poses a major threat.

Different company has their own method of arriving at their PAT’s.

Net Profit is calculated by subtracting all ‘expenses’ from ‘total income’.

This is where some companies play the trick.

How the companies record their expenses and income while accounting makes a big difference in the final outcome (Net Profit / PAT).

The real manipulations happens here.

There are ways using which companies can post higher sales and profit than actual. This companies does to keep the shareholders & stakeholders interested in their business.

Similarly, some companies also post lower profits than actual.

This companies does to minimize their tax liability.

In this way the stock of such companies will trade at higher P/E ratio.

Inflation & P/E ratio:

There is another factor which influences companies assets and profits but it does not immediately reflect in companies financial reports.

I am talking about inflation.

When inflation is soaring, input costs of companies will rise. But companies do not factor-in the impact of inflation immediately.

In a market where inflationary pressure is high, companies will have to spend much more than the provisions they have kept in terms of depreciation.

Higher inflation will result in higher CAPEX requirement to expand and modernize their operations.

But the provision of depreciation kept by the company may not be sufficient.

This means in future, if company will have to pay more for CAPEX it will eventually reflect in companies lower earnings.

But as these factors does not impact the company immediately, hence existing P/E will not show the actual picture.

## Examples to understand the limitation of P/E ratio

**Ex.1**

Suppose a reputed company is currently trading at P/E ratio of 12. Applying our rule of thumb, P/E ratio of 12 makes this stock attractive.

But it is possible that:

- The company has reported an inflated EPS,
- Though the present PE ratio looks attractive, but as the future profits of company is going to fall (due to inflation), it is not advisable to buy this stock.

**Ex.2**

Suppose a company has a low P/E ratio.

And this low P/E ratio has remained like that for quite a long time.

If a new investor will look at this low P/E ratio he will get an impression that this stock is undervalued.

But this may also be the case that, the company is in trouble. Knowing this fact, more people are avoiding this stock.

Hence its P/E is low.

**Ex.3**

Suppose a company has a low P/E ratio. This company has very recently launched its IPO.

A company which has recently launched its IPO is most likely to show high future growth rate.

In this way, this company having low P/E ratio means it is undervalued.

**Ex.4**

Suppose a company has a very high P/E ratio.

This company is among the top 5 companies operating in the market in terms of market capitalization.

Even though the company is very big, may still have a high P/E ratio.

This high optimism is possible only if the investors expect the company to grow very fast in times to come.

This typically happens with big MNC’s operating in different parts of the globe.

## Stock traders give too much importance to P/E ratio

There is a concept in stock market using which stock traders make money when price of stocks fall. It is called as ‘short selling’.

Stocks which are considered good for short selling must typically show high P/E ratio.

This is like a rule of thumb.

Expert traders make money by short selling, wherein they buy stocks with inflated P/E ratio, and sell them as soon as their price falls.

Yes, they make money if the price falls.

Too know about short selling, google the term and you will know.

But here lets keep our focus on the price earning ratio (P/E).

A novice trader may buy stock with high P/E ratio, assuming that its will fall.

But this assumption may be completely wrong.

Assuming that a stock is overvalued only on basis of P/E ratio can often lead to problems.

P/E actually cannot decide in isolation that that a stock price will fall soon.

The same theory is applicable for low P/E stock as well. A stock will low P/E ratio does not guarantee that its price is going to rise any time soon.

In general, stocks showing low P/E ratio hints at it being undervalued.

But further checks are essential.

Similarly, stocks showing high P/E ratio hints at it being overvalued. But further checks are essential.

Valuing stocks is much more than just looking at few ratios, and drawing conclusions.

One may start with P/E ratio, but more in-depth check-points must also be applied.

People who invest in growth stocks watch ‘high P/E stocks’ with lot of attention.

Because these stocks, due to its high P/E ratio, gives an hint that they have high future growth prospects.

Similarly, people who invest in value stocks watch ‘**low P/E stocks**’ with lot of attention.

Because these stocks, due to its low P/E ratio, gives an hint that they are undervalued.

But making these easy assumptions, based on P/E ratio is not advisable.

Compare P/E ratio of a company with its sector-industry P/E ratio. This comparison can be more conclusive.

One can also look at historical P/E movements of individual stocks to get an idea of whether its present price point looks below or above average.

In general a stock in India, which has P/E ratio of 15 can be treated as fairly valued. Inverse of P/E ratio is called as ‘Earning Yield”.

Example: Inverse of P/E=15 is 0.066. It means the earning yield is 6.66%.

Compare this with expected average inflation in India for next 15 years (6% per annum).

A stock which has higher earning yield than inflation can be considers as fairly valued.

## P/E Ratio is only partly reliable:

High and low P/E ratio is a stock metric which is half speculative and half fundamentally driven.

Market price component (P) is a very speculative stock metric.

While earning per share (E) is a stock metric which is derived from companies financial reports.

So, it is essential to treat P/E ratio with caution. Do not consider P/E ratio as your “The Litmus test”

But it is also true that P/E is a very valuable stock metric as it gives a great starting point to investors to do further analysis.

Stocks which has low P/E ratio can be both undervalued, and may also be that stock, which** has low future growth prospects**.

This is what investors must check with further *drilling into companies financial reports.*

## Final Words…

The price earning ratio (P/E) helps investors to identify those stocks that has deviated from their normal levels of valuation.

Assuming that nothing has changed in the company, sector or market, if price earning ratio (PE) is changing it means it is happening only due to speculative reasons.

These same speculative reasons at times makes stocks overvalued or undervalued.

The price earnings ratio (P/E) is one of the most common used parameters to judge true value of stocks.

It is calculated by dividing current stock price by earnings per share.

Earning per shall shall be earning of company (PAT) for the past 12 months.

The price earning ratio of a stocks is followed so closely because it reflects market expectations about future performance of the company.

If the market has low expectations about future performance of company, P/E ratio will be low.

Where there will be higher expectations for growth and reliability, investors will pay higher (P/E high) to buy that stocks.

This does not mean that all low P/E ratio stock has low growth potential. But value investors likes to invest in only low P/E stocks.

A company which has strong fundamentals but are trading at low P/E ratio are perfect buy for value investors.

Though the company has strong fundamentals but speculative forces overpowers its fundamentals and price fall to low levels.

The inverse is also true, stocks with weak fundamental may also trade at very high price levels.

Idea is this, just looking at P/E ratio of stocks does not give a complete picture.

We must check the fundamentals of the company to decide if low/high P/E ratio is justified or not.

Value investors believe that stock fundamentals will dominate in long term, but emotions often rule the short term.

Emotions can get the better of rational analysis (fundamental analysis), pushing the price beyond (high or low) the true value.

During periods of euphoria stock price becomes too high compared to its true value (PE ratio high).

During periods of pessimism stock price becomes too low compared to its true value (PE ratio low).

If we know PE ratio of Indian stocks, we can filter those shares that are undervalued .

The PE helps to establish benchmarks and identify companies that have deviated from their normal level of valuation.

Further to PE ratio, Indian stocks may further be screened on parameters of potential future earnings of a company (EPS growth).

Investing in stocks with low PE ratio and high EPS growth rate is ideal.

#### Quick Tip:

Keep watching Sensex and Nifty.

Track the movements of P/E ratio of Sensex. You can see the above extract from the historical P/E ratio of Sensex.

Whenever, in last 16-17 years, the Sensex’s P/E ratio has gone below the multiple of 16, the next year itself there has been a staggering jump in Sensex levels.

Between year 2003 and 2004, Sensex jumped by 83.38%. Between year 2009 and 2010, Sensex jumped by 80.54%.

Presently, in June’2017, the **price earning ratio (P/E) of ****Sensex** is currently trading at price/earning multiple of **22.37**

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