6 things to note about the P/E ratio

By Morningstar |  04-10-19 | 
 

The Price-to-earnings ratio is one of the most widely used tools for stock selection. Here’s a basic primer on the ratio.

  1. What is it?

Price-to-earnings ratio (P/E) looks at the relationship between a company's stock price and its earnings.

The P/E ratio gives investors an idea of what the market is willing to pay for the company's earnings.

  1. How is it calculated?

The ratio is determined by dividing a company's current share price by its trailing 12-month earnings per share. For example, if a company is currently trading at Rs 25 a share and its earnings over the last 12 months are Rs 1.35 per share, the P/E ratio for the stock would be 18.5 (25/1.35).

  1. What does it tell you?

As the P/E goes up, it shows that current investor sentiment is favourable.

A high P/E usually indicates that the market will pay more to obtain the company's earnings because it believes in the firm's ability to increase its earnings.

A dropping P/E is an indication that the company is out of favour with investors.

A low P/E indicates the market has less confidence that the company's earnings will increase; however, a fund manager or an individual with a 'value investing' approach may believe such stocks have an overlooked or undervalued potential for appreciation.

  1. What you must remember

Different industries have different P/E ratios ranges that are considered normal for their industry group. The average P/E ratio of a technology company will different from that of an FMCG or textile manufacturer.

Hence, P/E ratios must always be compared within industries because some industries that have a strong growth orientation tend to have high P/E ratios.

P/Es can also be artificially inflated if a company has very weak trailing earnings, and thus a very small number in this equation's denominator.

  1. Explain with regards to a mutual fund

A fund's P/E ratio can act as a gauge of the fund's investment strategy in the current market climate, and whether it has a value or growth orientation.

The P/E ratio of a fund is the weighted average of the P/E ratios of the stocks in a fund's portfolio.

  1. Explain with regards to the market

Nifty PE ratio measures the average PE ratio of the Nifty 50 components of the index. If P/E is 15, it means Nifty is 15 times its earnings. Nifty

In 2008, the Nifty P/E surged above the 28 mark. Last year, the Nifty sported P/E multiples at over 28. On May 23, the P/E ratio of Nifty on May 23 stood at 29.02. It is considered to be in oversold range when Nifty PE value is below 14 and it's considered to be in overvalued range when Nifty PE is near or above 22.

In October 2017, market strategist Ridham Desai and head of Morgan Stanley's Indian equity research team, tackled the subject of India’s high P/E.

The problem with looking at the PE ratio is that earnings is a cyclical variable that fluctuates. If earnings are high, the PE will appear low. Does that mean the market is cheap? Probably not because earnings will then fall.

If earnings are low, which they have been for the past 3-4 years, PE multiples are high. Does that make the market expensive? Probably not because earnings are going to rise. Since the market is forward looking, the PE is a bad metric to judge valuation.

 
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