So P/E ratio is another metric used by all the investors to know whether the stock is cheap or expensive with respect to other stocks of the same sector or the sector as a whole. If you invest in the stock market then I am sure you have encountered this ratio at some point in time.
Before diving into the formula and calculations of PE ratio, we must understand what exactly this ratio means. So in a non-technical terms PE ratio simply means how much the investor is ready to pay for 1 rs of earning of the company. This definition will be more clear once we look into the formula of PE ratio and how it is calculated.
Since it’s a ratio, so it has 2 components which will impact the result. The numerator is the current price of the stock you are going to buy and the denominator is the earning per share of that particular stock.
So the price is not a factor which is not in our hands. It depends for the demand and supply of that particular stock. But there are some penny stock whose prices can be manipulated by controlling the demand and supply. This is a normal thing in the stock market and is generally done by the operator and new investors should be cautious while investing in these penny stocks.
Now Earning per share is a metric which is calculated by taking the profit after tax (from the income statement of the company) and dividing it by the total no of outstanding shares. Now mind this, we need to consider only the outstanding share i.e the shares which are available in the open market for trading and not the total number of shares of the company. So by doing this exercise we will get the earning per share of the company.
Now companies can always manipulate this EPS by window dressing the accounts and playing with the loopholes of the accounting system. So investors should be aware of the red flags that can indicate such type of malpractices followed by listed companies.
So if we think logically, it is obvious why company management is never happy if their EPS decreases. This is because of the fact that if their EPS goes down, then at the current prices the PE ratio goes up, and if the PE ratio increases relative to other similar companies in the sector, then it shows that their stock is expensive which could lead to less demand and due to less demand and acting of market forces, the price of the share will eventually fall to reach an equilibrium which is not a desirable situation for a listed company.
So In the above example, I have taken 2 FMCG giants of India to show how the PE ratio is interpreted.
Sector PE = 42.57
ITC PE = 16.64
HUL PE = 69.58
So in general what PE signifies is,
In the context of ITC, if you as an investor is buying ITC stock at PE 16.64, this means that you are ready to pay a premium price of 16.64 rupees for 1 rupee of ITC earning.
In the context of HUL, if you as an investor is buying HUL stock at PE 69.58, this means that you are ready to pay a premium price of 69.58 rupees for 1 rupee of HUL earning.
Now if we see sector PE which is 42.47 is more than ITC and less than HUL. So since ITC PE is lower than sector PE, this implies that ITC shares are cheaper compared to similar FMCG companies like HUL whose PE is more than sector.
But we cannot always conclude this result as higher PE can also mean that investors or market as a whole is looking HUL as a very good stock and expecting higher returns so they are ready to pay more to buy the share, this increases the demand of the share and results in greater share price and greater PE ratio.
So as an investor PE ratio is a vital metric to look at before taking a call to buy a particular stock. Making a sound inference from the PE ratio is the art of an intelligent investor.
Until next time.