There are a number of ways to find out if a company is overvalued or undervalued or fairly valued. One such way is the PE ratio. In this article, I will show you how to use the PE ratio to understand the valuation of a company and What Is A Good PE Ratio In Indian Stock Market?
What is PE Ratio?
Price Earnings Ratio or Price to Earnings Multiple is the ratio of the share price of a stock to its earnings per share (EPS). PE ratio is one of the most popular valuation metrics for stocks.
It provides an indication of whether a stock at its current market price is expensive or cheap. Let us explore what is PE ratio, its different types, and how to use them in investment decisions.
PE Ratio Formula and Calculation
The formula and calculation used for this process are as follows. PE Ratio= market value per share/earnings per share
To determine the PE value, one must simply divide the current stock price by the earnings per share (EPS).
Understanding the PE Ratio
The price-to-earnings ratio (PE) is one of the most widely used tools by which investors and analysts determine a stock’s relative valuation. The PE ratio helps one determine whether a stock is overvalued or undervalued.
A company’s PE can also be benchmarked against other stocks in the same industry or against the broader market, such as the Nifty 50 Index.
Valuation From PE
The price-to-earnings ratio or PE is one of the most widely used stock analysis tools by which investors and analysts determine stock valuation.
In addition to showing whether a company’s stock price is overvalued or undervalued, the PE can reveal how a stock’s valuation compares to its industry group or a benchmark like the Nifty 50 Index.
The PE ratio helps investors determine the market value of a stock as compared to the company’s earnings. In short, the PE ratio shows what the market is willing to pay today for a stock based on its past or future earnings.
A high PE could mean that a stock’s price is high relative to earnings and possibly overvalued. Conversely, a low PE might indicate that the current stock price is low relative to earnings.
In general, a high PE suggests that investors are expecting higher earnings growth in the future compared to companies with a lower PE.
A low PE can indicate either that a company may currently be undervalued or that the company is doing exceptionally well relative to its past trends.
When a company has no earnings or is posting losses, in both cases, the PE will be expressed as N/A. Though it is possible to calculate a negative PE, this is not the common convention.
What Is A Good PE Ratio In Indian Stock Market?
As mentioned earlier, stocks in different sectors trade in different valuation (PE) ranges. Usually, stocks with higher earnings growth potential have higher PE ratios. Therefore, we cannot use a single PE level across all stocks to infer whether the price is attractive or not.
You should look at the historical PEs of stocks and see if the current PE is near the higher end of the range or near the lower end of the range.
If the stock is trading near the lower end of the range then it can be a good investment opportunity subject to other factors which we will discuss later.
As far as Nifty is concerned, it has traded in a PE range of 10 to 30 historically. The average PE of Nifty in the last 20 years was around 20.* So PEs below 20 may provide good investment opportunities; the lower the PE below 20, the more attractive the investment potential.
Limitations of Using the PE Ratio
Like any other fundamental designed to inform investors as to whether or not a stock is worth buying, the price-to-earnings ratio comes with a few
limitations that are important to take into account because investors may often be led to believe that there is one single metric that will provide complete insight into an investment decision, which is virtually never the case.
Companies that aren’t profitable and, consequently, have no earnings or negative earnings per share pose a challenge when it comes to calculating their PE. Opinions vary as to how to deal with this.
Some say there is a negative PE, others assign a PE of 0, while most just say the PE doesn’t exist or is not interpretable until a company becomes profitable for purposes of comparison.
One primary limitation of using PE ratios emerges when comparing the PE ratios of different companies. Valuations and growth rates of companies may often vary wildly between sectors due to both the different ways companies earn money and the differing timelines during which companies earn that money.
As such, one should only use PE as a comparative tool when considering companies in the same sector because this kind of comparison is the only kind that will yield productive insight.
Comparing the PE ratios of a telecommunications company and an energy company, for example, may lead one to believe that one is clearly the superior investment, but this is not a reliable assumption.
In this article, we discussed what is PE ratio, what is a good PE ratio in Indian stock market and how it is used in investment strategies, and its limitations.
PE ratio is a great metric for stock and index valuation, but most investors use it in conjunction with various other decision factors like sustainable business model evaluation, competitive advantage, market share growth potential, earnings growth prospects, low to moderate debt-equity ratio, and strong management team.
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