There are numerous stock analysis tools available to investors and the Price to Earnings (PE)ratio is probably the most widely used of the lot. So,what is PE?
It is simply the ratio calculated by dividing the current market price of a share by earnings per share. So, if the share price of XYZ Company is Rs. 200 and the earnings per share is Rs.10, then effectively, the PE ratio will be 200/10 = 20.
Why is the PE ratio helpful?
The PE ratio helps investors determine the relative value of a company, either in comparison to its competitors or its own past performance. In simple terms, the PE ratio helps understand how much you are paying for a stock based on the company’s earnings.
A high PE ratio tells you that the share price may be high compared to the company’s earnings, indicating that the stock is overvalued. Conversely, if the PE ratio is low, it indicates that the stocks may be undervalued.
How to use the PE ratio?
It is essential to compare the PE ratios of various companies with their peer group sector.PE ratios vary across different sectors. What may be a high PE for a consumer goods company may be relatively low for a company from the new-age tech sector. Also, smaller companies often have higher PE ratios than the industry averages due to higher sales and earnings growth rates.
Understanding PE fluctuations
It is also seen that during the bear phase of the market, stocks tend to have lower PE ratios, whereas in bull markets, the ratios are higher as compared to the average historical values. Analysts believe that stocks with low PE ratios but with high earnings growth are considered good bargains.
So, what is a good PE ratio?
NIFTY’s PE ratio today(as on October 26, 2021) is 27.19. Most companies in the Indian stock market have PE ratios ranging from 5-20; however, blue chip companies tend to have PE trade of between 10-30. PE ratios indicate what an investor is willing to pay to buy any particular stock.
So, we can see that PE ratios depend on the current market trend, the historical average and the sector to which the particular stock belongs. Hence, it is prudent for an investor to not look at the absolute value of the PE ratio in solidarity, but to also consider these other factors while making an investment decision.
What you must keep in mind while using PE ratios
One drawback of the PE ratio is that a company releases its earnings every quarter, whereas stock prices fluctuate every day. So, the PE ratio may not be much helpful for short term investors or traders.
A low PE stock might not always be a good investment because the unattractive future growth prospects might be keeping its value down.
To sum up, we can say that the PE ratio is a helpful indicator of value for investors, provided it is used after considering other factors to invest in stocks. Its use does not require in-depth technical knowledge and is hence popular amongst both beginners and experienced traders. You can still consider consulting a financial expert when planning your portfolio and making investment decisions for better guidance.