How P/E ratio can be used
What is P/E ratio?
In some words P/E ratio = Current stock price / EPS (Earnings per share) of the year.
Here, Current stock price is the price at which trading is going on or the latest close price of a stock and EPS is Earning per share of recent 4 quarters which is also know as TTM EPS (Trailing 12 months ). Lets take an example and calculate the P/E ratio for a company for better understanding.
Lets take XYZ Industries.
Current Price – 2840/- For EPS let me show you what data you need.
So TTM EPS = 28.53+ 23.67 + 25.71+ 25.52 = 103.43
So P/E ratio = 2840/103.43 = 27.4
Now PE ratio is available at many places but its important to understand where it comes from for knowing its significance.
Significance of P/E ratio:
P/E ratio gives us an idea on the valuation of the stock or company. There is a saying that a lower P/E ratio means the valuations are attractive whereas a higher P/E ration means valuations are expensive and the stock shall be avoided. So, that means the P/E ratio shall be taken at its face value ? A stock with 5 P/E is cheap and a stock with 40 PE is expensive ? No not at all, this is the biggest misunderstanding many have with P/E ratio. The nos. straight to its face value can be a trap. So, in short significance of P/E ratio is to give an idea on valuations of a stock but we can not just take it to its face value. So, how to extract a better meaning from P/E ratio to help it make our trading or investing better.
Breaking down the P/E ratio: “Mark Minervini” says in his book “Trade like a Stock Market Wizard” that many growth stocks with huge potential for earnings growth in near future may be trading a higher P/E ratio which seems expensive to many. Lets understand this in depth as not all stocks with higher P/E value will be from growth space.
Lets take an example of a higher PE stock: ABC Ind in May 2023- July 2023: Now this example was trading at a P/E value of 87 on the day shown below. So, as per the face value it seems very expensive isn’t it and shall be avoided. This is what many does by taking P/E at face value instead of looking what growth opportunity the company is having in future as “Mark Minervini” says. Now if we would not gone by the face value but would have checked the growth perspective then following factors could have been surfaced: Its a Sunrise sector as it belong to Electric vehicle which is expecting a good growth going forward because of the shift to EV’s from conventional vehicles. Company has a very Good order book which shows good earnings visibility. Expansion is under way which is going to increase the execution capacity to have a clear growth perspective
If you all are wondering what is a Sunrise sector and how to extract all the above information, don’t worry we will touch all the factors as we go on. Let me explain the same thing in a different method. P/E ratio as we learned is Price/Earnings , So we have earnings in the denominator. If earnings increase with time in next few quarters then the denominator will become heavy right ? The P/E ratio will ultimately come down because of its future growth assuming price remains same. This shows that in future its P/E value is coming down and depending on growth potential it may come to a no. where its valuation looks really good. (If the Growth opportunity is in such a way) Now mostly stocks appreciate in price in good market environments which we mostly call as Bull markets, so market many a times may discount the future in favorable markets in expectation that the future earnings will take care of the valuations. Say market take the P/E to 150 because of the price appreciation now when the earnings in next few quarters gets better P/E will start to get normalized. Now this is also called “Growth Stock Investing” So, in our example market did the same things giving a price appreciation to the company looking at its future potential.
So till now we understood that a higher P/E ratio doesn’t make the company costly just by its face value. We need to dig deeper to come to a conclusion. Now lets take an example of a lower P/E stock to understand a low P/E always doesn’t mean an opportunity. Lets take an example of a Lower PE stock: Example- XY paper Now it traded the whole year within a P/E range of 5-8 which looks really cheap just by its face value but market did not give value to the stock by appreciating its price. Why? Just because of the opposite reasons it may have compared to the High P/E example. It belongs to sector which may be loosing its value because of Digitization so , in future growth might not be their. So, now by face value it looks cheap but when we dig deep it isn’t exactly as market is not favoring the sector
Conclusion:
Now we know how to calculate P/E ration and what is the significance. Also we understood that a higher P/E doesn’t always mean a expensive stock and lower P/E doesn’t always indicates a cheap stock. Future of the Sector or company can be thought of to make a decision on whether it has growth potential or not.