P/E ratio is one of the famous,valuable and most used ratio to analyse a stock. The full form of P/E ratio is price to earning or price upon earning. This ratio is used shortly but misused mostly to analyse a stock by people because they do not have a proper knowledge about it. In this article all the information to understand pe ratio like” what is p/e ratio?”,”how to analyse good p/e ratio?” is discussed.
What is pe ratio?
P/E ratio represents if any company distributes its all profit to its shareholder and the company grows uniquely or performs same in next future years then that much time(years) will be taken to recover the invests (like rupees) of each share. Let’s understand with an example:
If someone invest 1000 rupees in ‘pq’ company and the pe ratio of this stock is 2 then his/her invest will be recovered in 2 years if company performs or grows uniquely.
Formula of pe ratio :
P/E=(share price/EPS)
*(EPS means earning per share.if any company distribute its all profit to its shareholders then that much money(earning) will be got by shareholders for each shares. EPS= earning/share).
Let’s understand pe ratio stock with an example :
Think about 2 company name X and Y. Share price and EPS of X company is 100 and 10. And share price and and EPS of Y company is 200 and 10. It means the pe ratio of X company (calculate with pe formula) is 10 and the pe ratio of Y company is 20.
| Company name | X | Y |
| Share price | 100 | 200 |
| EPS | 10 | 10 |
| P/E | 10 | 20 |
It looks like that company X is undervalued and company Y is overvalued.Then we should buy X company. But in real X company may be not undervalued. If it is so easy then everyone learn value investing.
But it is not so easy as it looks or people say and also it is not so hard to understand.Let’s discuss pe ratio’s exception,complication and careful use.
What is good pe ratio stock?
If any company’s EPS is 10 and share price is 100 then it’s pe ratio is 10. If you buy the stock then you have to pay 10 X more of today’s share price. How much more money should we pay to buy a stock?
If pe ratio is low then it must be to be that the share price is low, it has no guarantee. It may be other investors do not have faith on company’s future growth.
Usually people know if pe ratio is low in stock then price of this share is undervalued and if pe ratio is high then the share price is overvalued. This theory have no base in stock market.
Because of low pe ratio may be the bad management of this company or bank correpted or takes high debt etc. So investors wants to keep distance from this stock.
Some people buy stocks only the cause of low pe ratio.it is not right. That all company which may be bank corrupted or sell the company in future these stock have also low pe ratio.
If pe ratio of a stock is high then it must be overvalued it have no guarantee. The reason of high pe is investors have confidence on the future growth of this company or the company performs well or the future goals of this company is strong and profitable for investors.
If you get a low pe share you should not buy with the help of one ratio. You have to check other financial ratios and do fundamental analysis. When you go to buy a shoe i think you surely check shoe’s lether, cloth, flexibility, price, longibility etc.you do not buy any shoe without checking quality. If you get a quality shoe in low price then it is a great deal.
You have to know why the stock’s pe ratio is low or high. Another reason of low pe is one time profit in business. So earning became high and pe ration become low.Another reason of high pe is bad time of well management company. So you have to find the reasons of high or low pe ratio. For these you should have to check other financial ratios. You should not depend on one ratio.
How to analyse pe ratio stock?
Let’s think X company earns (per share) 5 rs two years ago.10 rs previous years and 15 rs this year. Now it is not so hard to imagine the earning or profit of this company in next year. The growth of this company is same in every years about 5 percent(like textiles companies) . So the pe ratio of this stock is always low because its growth is very poor.
On the other hand, company Y earns(per share) 4 rs two years ago,12 rs previous years,25 rs this year then obviously profit will be more in next year. The growth of this stock is high so its today’s pe ratio is high but when its profit grows,the pe will be decreased.
| Profit per share | 2018 | 2019 | 2020 |
| X | 5 | 10 | 15 |
| Y | 4 | 12 | 25 |
Are you confused ?solved it with an example:
Imagine company Y pe ratio was 20 previous year.calculate the formula,each share price= 20*12=240rs. Now company grows this year and earns(per share) 25 rs and share price is 240 rs. pe ratio in this year= 240/25=9.6 . Look the difference of two years. If other ratio and fundamental analysis is good for buying then high pe is not matter there.
To compare any company’s pe high or low, you can check the whole industry pe ratio and compare it with individual company. Like M pharma company’s pe ratio 5 and whole pharma industries in stock market is 10. Then obviously pe ratio of M company is low.
Pe ratio have no role to analyse in some companies like real estate. Because in these companies sell or earning does not growth in a way every year.That year real estate companies sell more flat or land ,pe ratio of this stock become low this year. Next year company may not be sell more like this year. Then pe ratio will become high .pe ratio in tn these companies are not valuable.
To pick or add a stock in your portfolio you should check the pe ratio with other financial ratios like p/b and also do company’s fundamental analysis. Good pe ratio is an important factor but you should not buy with the help or depend on one ratio.
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