Most of the time, in the stock market investments we hear about PE ratios of like: for company X PE ratio has come down to make it more attractive or PE ratio of company Y has gone extremely high to make it overvalued. Do you understand what they mean? If not, Let us try to understand what this ratio is and then we will decide do we need to bother about it or not.
P/E Ratio is nothing but Price to Earnings Ratio. It explains the relationship between the stock price and company’s earnings. It is calculated as below:
P/E Ratio = (Market Value per Share)/ (Earnings per Share)
Market Value per Share = Current market price of the stock
The earnings per share is the net income of the company from the most recent results published by company divided by number of outstanding shares of the company.
Annual Earnings per Share (EPS) = Net Income / No. of Shares
Example: Canara Bank is having a share price of Rs. 440/- and its EPS is Rs. 84. Then the P/E Ratio of Canara Bank would be 5.24 (440/84).
But what does P/E Ratio explain?
First thing, P/E Ratio gives you an idea of what the market is willing to pay for the company’s earnings. It helps an investor compare the valuations of a stock to that of its peers and in the same industry.
Some Interpretations are:
Higher P/E: it means that stock is overvalued but market, in expectations of higher earnings growth, is willing to pay that extra money. But, some investors look at it in a different way. They will say company is overpriced as compared to its peers so it is not advisable to pay higher price.
Low P/E Ratio: It indicates “Sign of no-confidence” by the market which means the investors have undervalued the stock due to lack of confidence in its future growth. However, it could also mean that this is a stock which has been overlooked by the market and does possess strong future growth potential.
A low P/E ratio stock can become a “Value pick” before the rest of the market discovers its true value.
Do not depend only on P/E Ratio, but use this as a very directive tool. The PE Ratio should match the growth rate of company. If it is matching the growth rate then you can call it as fairly valued stock. If Growth rate is more than PE Ratio, means the company is undervalued. If Growth rate is less than the PE Ratio, then the company is overvalued.
Let’s try this learning in identifying some value picks based on PE ratios, in the below chart: we mapped the PE ratios of various banks in Increasing order.
The average PE ratio of the banking industry is ~10.3 but it does not men all the banks with PE ratio less than 10 are attractive or all the banks with PE ratio more than 11 are costlier to buy. One thing you can notice that most of the banks with PE ratio >11 are private sector banks. intuitionally you can say that the private banks are more nimble in its operations and better managed so their earnings growth is better than public sector banks, so its justified.
Now the issue is how to select our value pick? Let us see in PE ratio chart we can see among Private sector banks Indusind bank and Yes bank had the strongest performance yet the Yes bank has the Lowest PE multiple and Indusind does not have the highest multiple. This indicates that the upside opportunity in Indusind bank and Yes bank is more likely than any other private bank in list. But one should also read and make sure that the strategy of these banks should be aggressive for next few years to sustain their high growth.