Understanding P/E Ratio

If you have ever shown interest in stock markets, ever traded stocks, or ever read a stock tip, then chances are you would have heard about this fancy term: the P/E ratio.

This is the most widely used (or misused) financial ratio when deciding about intrinsic values of stocks. Analysts (the so called know-it-all persons) often boast about their knowledge by talking about P/E ratio of their stocks. And the retail investors not knowing much about this are left dazzling. Here, I would try to simplify this smart ratio for you. We will discuss what this ratio is, and more importantly, what this not is.

In the most simple terms, P/E is Price to Earnings ratio. It is the ratio of price of a company’s stock to its Earnings per share.

P/E = Price of Stock/Earnings Per Share

Ideally, this ratio tells how much an investor is willing to pay for a stock for each dollar of its earnings. So, for a stock having P/E of 25 would mean that an investor is willing to pay $25 for $1 of the earnings of the company. Don’t think that I took P/E of 25 as an imaginary figure. Traditionally P/E varies between 15 and 30. In fact, there are many companies with P/E above 100 too!!

So, what does P/E ratio mean? Does it mean that you should buy companies with low P/E ratio as they are available at a lesser premium to their earnings. Or you should never buy companies with high P/E ratio as they are supposedly expensive. This is where P/E ratio’s usefulness and shortcomings come into picture. Sometimes P/E ratio seems to be highly incomplete. It takes into account just the earnings of the company, but completely ignores growth potential, future prospects, assets etc. If a company made some temporary losses in the current year, but is poised to have huge profits next year, then its P/E ratio is still going to be negative. This is a misleading picture.

There is no suggested value of P/E ratio at which you should buy a stock. P/E ratio varies from sector to sector. For some sectors, P/E ratio is inherently high as they are on a fast growth trajectory ( IT is an example), and for some sectors P/E ratio is very low despite the fact that the sector is very big with huge profit making capabilities. Within sectors also, P/E ratio varies from stock to stock. Good stocks normally have a higher P/E ratio than their counterparts. This is because of the simple demand and supply principle, more investors are willing to buy good stocks, and hence they are available at a premium.
For a retail investor, the simplest way to use a P/E ratio is to compare P/E ratios of companies in the same sector. P/E ratios are available for forecasted earnings also. So, you may try to find stocks that have lower current P/E ratio but higher future P/E ratio. This would mean that the company is available for cheap now, but the company is set on a growth trajectory. So, there are more chances of such stock giving better returns than the already existing biggies.

In the end, I would like to conclude by just saying that P/E ratio is a beautiful tool in the hands of the investors that tell them about the picture of the company. However, do not use it as a crystal ball. It is not a means to an end. Use this just as a starting point in your search good companies. And once you have shortlisted companies, dig further into financials to ascertain that everything is fine there. Balance sheet and Annual reports are very good sources of information about a company (I would discuss regarding these in my some future article).

I hope now you won’t be amazed by an analyst’s blabber about P/E ratio. Now you know exactly what this is, and what this is not.