Investing in stock market gives you an opportunity to accumulate wealth in the long run. Everyone would want to grow their wealth and equity market is the only asset class which helps you to earn high returns. Not only it gives you the opportunity to earn high returns but also tax efficient returns.
But a major problem that most of the investors face is how to pick stocks. Although you are very much interested to earn through stock market but it is equally important to be informed and gain knowledge to make best out of stock market.
Well, you can do it yourself by equipping yourself with more knowledge on stock market. Alternatively, you can seek the help of a financial advisor.
Some of you might be aware that you can check some financial ratios to understand more about a stock. This makes it easy to pick your stocks. In this article, we will focus on one of the key ratios and also one of the most popular i.e. P/E ratio.
We will start by understanding the basic meaning of P/E ratio. P/E stands for Price to Earnings ratio. It is a measure of a company’s current stock price relative to its earnings. It gives you a fair idea as what the market is willing to pay for a given company’s earnings. The simple formula is
P/E ratio = Market Price of the share / Earning per share
Let us take an example, say market price of a share is 200 and Earning per share is 20. We can thus calculate P/E ratio as 10 (200/20).
To put it in simple words, we can say P/E ratio is the price an investor is willing to pay for earnings of one rupee from that share. So, in the above example, we can say that investors are paying Rs.10 for one share and this one share has an earning of one rupee.
How it is useful?
It is useful ratio for evaluation of attractiveness of a company’s stock price compared to its current earnings. If you’re trying to figure out whether a stock is a good investment or not, the P/E ratio can assist you to understand the future direction of the stock and whether the price is high or low compared to its earnings or other companies.
Interpretation of P/E ratio
There is no standard number which we can say is an ideal ratio and compare it with that. Instead, it is more of a relative concept. This we can study in comparison of the stock with its own performance or industry performance.
Usually a high P/E ratio means that investors are bullish on the stock and expect company growth in future and that is why they are ready to pay a higher price now for that stock.
On the other hand, a low P/E ratio is interpreted as bearish view of investors on company’s growth in future. This is the reason that they are willing to pay a low price.
There is one more side to look at it. High P/E ratio can also mean that the stock is overvalued. Similarly, low P/E ratio can mean stock is undervalued. The concept of value investing is based on this. Let us see how.
It is based on P/E ratio that many stock market investors or mutual fund managers pick stocks. The strategy is called as value investing.
What is value investing?
It is a strategy that involves picking stocks that appear to be undervalued. Value investors actively look out for stocks they think the stock market is underestimating.
How P/E ratio help in this?
Well, as discussed earlier, a high P/E ratio could mean that a stock’s price is expensive compared to earnings and is overvalued. Same way, a low PE ratio may indicate that the current stock price is cheap in comparison to earnings.
So one can invest in low P/E ratio to take advantage. But it is not that simple and there are factors that you need to be careful of.
Must Read – How to pick stocks on the basis of P/E ratio?
So how to decide?
P/E ratio varies from industry to industry. Each industry have a different range of PE ratio that is considered normal. For Some sectors, P/E is a high number whereas for other sectors P/E is a low number. So a P/E of stock of X industry should not be compared with a P/E of stock of Y industry.
what should be done then?
1. It is suggested to compare a stock P/E ratio with its own past PE ratio to get an idea how it is performing.
2. Next, it is recommended that peers with same business activity and of similar size should be compared. This means compare P/E of other companies in the same sector.
3. It is important to note that you should not fall in value traps. This means investing in stocks which are underperforming and not undervalued.
4. Apart from PE ratio, you should also check other factors about the company like customer retention, management of the company, cash flows, past consistency in growth etc.
All these measure will ensure that you are making an informed decision in picking up a stock.
I hope you now have a better understanding of PE ratio.