PE ratio helps an investor pick stocks
investors hould aim at picking up stocks with a low price earning ratio (PE ratio). The term PE ratio is commonly used in investment decisions. Investors rely on this ratio to base their investment decisions in equities.
Simply stated, a P/E ratio is the ratio between the market price of the share and the earning per share. The ratio tells us how many times the market price of a share is vis-a-vis its earning. According to one view, lower the PE ratio, the better it is for the investors, as there are chances of appreciation, and vice versa. Moreover, the risk element also increases. According to others, it is the other way around. However, there are exceptions to these rules.
A PE ratio is a valuation ratio of a company's current share price as compared to its per share earnings. It is calculated as market value per share divided by earnings per share (EPS). For example, if a stock price is Rs 100 and it has an EPS of Rs 5, the PE ratio is Rs 100 divided by Rs 5, that is, Rs 20.
EPS is can be taken for the full year, the last few quarters or it can be taken from the estimates of earnings expected in the next few quarters. Sometimes, the PE is referred to as the 'multiple' , because it shows how much investors are willing to pay per rupee of earnings . In general, a high PE means high projected earnings in the future. However, the PE ratio does not actually tell us a whole lot by itself. It's usually only useful to compare the PE ratios of companies in the same industry, with the market in general, or against a company's own historical PE ratios.
The higher the PE, the more you are paying for an estimated stream of earnings. Investors are usually willing to pay a higher PE for companies they judge will be growing faster than the norm, even though they do not pay those earnings out in dividends but retain them to fund future growth. If that growth is realised, the price of the company's stock usually grows faster than the overall stock price of a slower growth or higher dividend-paying company. However, if estimated earnings are not realised or the stock market itself loses favour with the investors, the downside potential is greater as well.
The risk is not just the ability of the company to create profits, but the investment risk in the higher price one paid relative to earnings . If a company goes from a PE of 50 to a PE of 25 and maintains earnings of Rs 5 a share, your investment goes from a value of Rs 250 per share to a value of Rs 125 per share, even though the company is still earning profits.
PE ratio is a commonly-used way to value a company and to determine what a company's stock should be worth. It gives an indication of how many times one is paying for a company's stock against the company's earnings. PE ratios can be used to compare one company with other companies, or against a company's own historical PE ratios. Generally, a company with a high PE ratio is expensive as against a company with a low PE ratio, since with a high PE ratio one is paying a larger multiple than the company's earnings. Higher PE ratios are often associated with 'growth stocks' , or companies that are growing faster than the average. Investors believe that the company's earnings will be higher in the future. Usually, this yardstick is used to analyse whether a stock is undervalued, overvalued or trading at fair value.
In the present market scenario, investors may pick some good low PE stocks, which have a high potential for growth.