Dive into the world of PE Ratios! Learn how Price-to-Earnings Ratios influence investment choices. Discover strategies, case studies, and tips for better stock selection.
In the dynamic world of investing in stocks, making informed decisions is paramount. One crucial tool in an investor's arsenal is the PE Ratio, or Price-to-Earnings Ratio. In this 5 minute read, we will attempt to demystify the PE Ratio and explore how it should ideally influence your investment decisions.
The Price-to-Earnings Ratio, often abbreviated as PE Ratio, is a fundamental financial metric used to assess the relative value of a stock. It's a straightforward concept: the PE Ratio tells you how much investors are willing to pay for each dollar a company earns. It offers a quick and insightful way to gauge the market's perception of a company's future earnings potential and the level of risk associated with a stock.
Understanding the PE Ratio is not just about numbers; It's a barometer of investor sentiment and expectations. A high PE Ratio may signal optimism, while a low PE Ratio could indicate market skepticism.
So, What exactly is the PE Ratio?
At its core, the PE Ratio is the ratio of a company's share price to its earnings per share (EPS). A high PE ratio is generally associated with expensive valuations for a Company’s stock price while a low PE ratio signals that valuations are currently attractive for the target Company. Lets take a live example: If Reliance Industries generated an EPS of Rs. 150 in FY23 and the Market Price on 1st April 2023 was 3,000/-, then its PE Ratio is calculated as 3000 / 150 = 20x (times)While both are important, trailing and forward PE Ratios serve different purposes. When future financial estimates are not easily available for a Company, analysts typically value the Company’s stock price based on the most recently available financial information such as the trailing 12 months EPS. Where a company is being actively tracked by Research Analysts on the street, it is more relevant to understand how the Company is currently being valued based on future earnings. After all, the Current Market Price of any Stock is a reflection of the future earnings potential of the Company! The Main Course A high PE ratio is generally associated with expensive valuations for a Company’s stock price, which basically reflects the optimism around its future earnings potential, while a low PE ratio, while signaling that valuations are currently attractive for the target Company, may also suggest that the market (it is infinite wisdom) is skeptical about the future earnings growth prospects of the Company. However, the PE ratio is a tool that must be applied carefully across different industries, especially those which involve inherent cyclicality in their business fortunes.
PE Ratio for indices: NSE (National Stock Exchange of India) flagship Index called as NIFTY 50 computes the Index PE Ratio based on dividing the index by the combined earnings of all its 50 constituents. The methodology of calculation of PE Ratio for NIFTY 50 Index has undergone a dramatic change in recent years. Prior to April 2021, NSE used to publish the Standalone PE for Nifty 50 which basically took into consideration only the standalone earnings of the Nifty 50 Stocks. April 2021 onwards NSE takes into account the Consolidated earnings of the same Nifty 50 Companies. This is important because fundamental analysts focus on the Consolidated earnings of individual companies than mere standalone earnings. From an index perspective, a cursory look at the PE Ratio for the Index can quickly tell an investor if the Index is currently overvalued or attractively valued. For Example, the PE Ratio of Nifty 50 as 13th October 2023 stands at ~22.3x (times). Based on historical data one can conclude that currently the Nifty is not exactly in an overvalued zone and probably has some more legroom to continue its current bull run.
To conclude, while the PE Ratio is valuable, it's not without its limitations. The “E” (Earnings) in the PE Ratio, which is basically the Earnings Per Share (that is nothing but Total Net Profit After Taxes divided by the total number of outstanding shares in the market), can be manipulated by Company management to juice or suppress the underlying valuation. Additionally PE Ratios differ from industry to industry as well as based on market capitalization segment (large cap vs smallcap). Eg. A high PE ratio in a cyclical industry might actually signal an attractive opportunity to get invested as current earnings profile of the Company might be suppressed due to underlying macro considerations which might not be permanent in nature. Conversely when a Company shifts from being a loss making Company to generating small profits, the PE ratio might throw up a crazy number (think of loss making Start Ups such as Zomato or Paytm).
So how should one really use this tool?
One of the most widely used tactics adopted by Investment Analysts is to not look at the PE ratio in isolation. It is better suited to do a relative (peer) comparison of the PE ratio of different companies in the same sector while also comparing the historical movement of the PE ratio across various market cycles. For example, in cyclical industries, the PE ratio is almost always at the lowest end of the band when the earnings cycle is peaking out for the industry and vice versa. Additionally one must also compliment using the PE Ratio with additional relative valuation ratios such as Price-to-Book (P/B), Enterprise Value-to-Sales (EV/Sales) and Enterprise Value-to-Earnings Before Interest Taxes Depreciation and Amortization (EV/EBITDA) to get a complete picture of where the stock stands on the valuation curve.