More about P/E

Hi there,
Let’s catch up with P/E ratio in detail. Before that, here’s a re-cap of what P/E is all about.

WHAT IS P/E RATIO?

  • Price to Earnings ratio is jargon used by investors and analysts.
  • P/E is one of the most commonly used valuation methods in the world of investment.
  • It is used to measure how cheap or expensive a stock is.
  • It has the ability to explain long-term return potential of a stock. P/E is ‘market price of the share’ divided by ‘earnings per share’.
  • It is the amount of rupees the market is willing to pay for one rupee of the company’s earnings or to put it in another way, it is the number of times the share of a company is priced in the stock market compared with its earnings.
  • The inverse of this ratio is known as the earnings yield.
  • The commonly used time-frame to calculate price-earnings multiple is the trailing 12-month period.

  • DETERMINANTS OF P/E RATIO

    The P/E multiple of a company is determined by many factors but the key determinants are (a) Expected Growth Rate (b) Current and Future Risk and (c) Current and Future investment needs.
    (a) Expected Growth Rate -Companies with a higher expected growth rate in business normally trade at a higher P/E multiple, as the earnings are expected to be more attractive in future. When the estimated EPS is higher, the forward P/E is lower compared with the current P/E. So, when the market gets this information, the share price goes up as then investors would be willing to pay a higher price for the stock. Therefore, companies with higher growth rates trade at higher P/E multiples.
    (b) Current and Future Risk -Companies perceived as risky usually trade at lower multiples, as the market expects fluctuations in their operating results.
    For instance, companies with higher operating leverage (higher proportion of fixed costs to total costs) and higher financial leverage (higher debt/equity ratio) are perceived to be riskier, by the market.
    (c) Current and Future investment needs-P/E ratio is also affected by the reinvestment needs/requirements of a company. For example, a company with higher reinvestment needs is perceived as riskier, as it would then require the company to borrow more funds. This may lead to a higher financial leverage or earnings dilution for existing shareholders depending on the method adopted to raise funds.

    TYPES OF P/E

    Trailing  P/E Ratio – Current market price divided by its last year EPS.
    Forward P/E Ratio – Current market price divided by its estimated next year EPS.

    WHICH ONE TO USE?

    While these two are the most commonly used P/E ratios — as both are based on actual earnings and hence the most accurate — it is forward PE that holds more relevance to investors when evaluating a company.

    PRACTICAL TIPS WHILE USING P/E

    Tip 1.Note that the P/E multiple comes down drastically due to the steep increase in the forecast EPS; the opposite holds true for a steep decline in the forecast e EPS number. All the variants of P/E are based on the same numerator (i.e. market price per share) but use different denominators (i.e. earnings per share- historical, trailing, forward and future). You can also consider taking the 6 -12 months median market price of the share for computing the price to earnings multiples.
    Tip 2.Value investors tend to adopt a low PE as a rulebook for an investment. While a low PE multiple is desirable, it would be inappropriate to adopt this ratio as a stock-picking tool across industries. Technology stocks tend to quote at trailing 12-month PE multiples between 30 and 40 compared to basic industry stocks that usually have single-digit PE multiples. As such, investors would be better off adopting this tool for peer comparisons within the same sector.
    Tip 3.This tool bypasses investment opportunities in companies that are making losses and are on the verge of a turnaround. So that’s another area to be careful about while analysing companies.
    Tip 4.Adopting moderate price-earnings multiple as a filter, an investor would also miss out on companies with substantial growth prospects.
    Tip 5. Companies that are just out of the red would be off the radar as they tend to command high PE multiples. Take the case of an investor who had adopted this tool in September 2003. SAIL, which traded at Rs 40, would not have been on his radar then as it quoted at about 60 times its trailing 12-month (standalone) earnings. Within a span of three-and-quarter years, the stock doubled to about Rs 80 (commanding an earnings multiple of 8).
    Tip 6.Going by a low PE would also filter out most stocks in the retail, media and technology space and leaving only those in the basic industries. A good number of stocks with a low PE are those perceived to have little opportunity for earnings growth or are highly volatile.

    Therefore, while the PE multiple is the most commonly used valuation metric, it cannot be the only one you use to decide on an investment
    Have a nice Day !

You may like these posts:

  1. Price to Earnings ratio or P/E ratio
  2. Understanding Earnings Per Share (or EPS)
  3. Introduction to financial ratios

2 Responses to “More about P/E”

Madhusudhan

January 8, 2013 at 2:47 am

where can i find Forward P/E ratios. I checked in Moneycontrol, but was unable to find the details.

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