Stock investing requires investors to carefully analyse the company’s financial data to find out its real worth. Investors often look at the company’s financial statements like P&L, balance sheet, etc to gauge its financial position. This can require a significant amount of time and effort. Therefore, an easier way to gauge a company’s financial situation and which is often used by investors is ratio analysis. These ratios are also freely available for investors to examine.
One such ratio that helps investors make investment decisions when it comes to stocks is the price-to-earnings ratio or P/E ratio. This ratio is used for stock valuation by investors and analysts alike. It helps them know whether a particular stock is undervalued or overvalued. P/E ratio can also be used to compare the stock valuation against benchmarks or peer stocks.
Among seasoned stock market investors, there is a preference for high P/E stocks due to the belief that these provide better returns. Here, we will try to understand whether high P/E stocks should be preferred and what are factors that investors must note before investing in these.
Basics of P/E ratio and how does it work?
P/E or Price-Earnings ratio reflects the relation between stock price and earnings per share or EPS of a company. It shows market expectations versus what investors are paying per unit of a company’s earnings.
Every stock investor would want to know the profitability of the company and its future prospects. With the help of the P/E ratio, investors can determine the stock’s profitability by measuring its market value against the company’s earnings.
In simple terms, the P/E ratio is a reflection of how much the market is ready to pay for stock as per the historical and future expected earnings of the company.
Calculation of P/E ratio
To calculate the P/E ratio, we need to divide the price per share of a company by its earnings per share or EPS. Mathematically, this can be represented as:
P/E ratio = Share price/Earnings per share (EPS)
Earnings per share or EPS is that portion of a company’s earnings after payment of interest due on debt if any and taxes, if any. This is set aside for the outstanding shares of the company. EPS is used by investors to gauge the financial strength of a company. It is calculated as below:
EPS = Total earnings after-tax/total number of outstanding shares
With the help of the P/E ratio, an investor can understand whether the market price of a share or stock is justified when measured against the company’s earnings.
Recommended read – How to analyse a stock to invest better?
What does a high P/E ratio mean?
A high P/E ratio means the current price of a stock is higher as compared to the earnings of the company. This means the stock could be overvalued. On the other hand, a low P/E ratio means that the stock price is lower as compared to earnings of the company and therefore it may be undervalued.
Value investors are known to avoid investing in stocks with high P/E or overpriced stocks since it indicates higher risks and speculative returns. High P/E stocks also indicate inefficiency in fund management on part of the company.
If a stock has a lower P/E ratio, it indicates that the stock prices are undervalued as compared to the company’s earnings. Value investors prefer such stocks and invest in them at lower prices to sell as soon as the prices rise.
Such investors may prefer to remain invested in undervalued stocks for a longer-term. When the company shows indications of attaining full profitability, the investors may exit. While this is the general interpretation of the ratio, we cannot assume that the share price is high or low only due to the company’s performance, since there could be many other factors affecting stock prices.
What should investors note before investing in high P/E stocks
Some important factors that investors should consider before investing in high P/E stocks are:
A high P/E means higher stock prices. However, higher prices may not always result from a company’s performance. If a high P/E is resulting from external factors, there are chances that the price may not remain high in the long run. Also, in case a company issues fresh stock, its EPS may come down and this could also result in a higher P/E. A company with lower earnings may also end up having a high P/E due to lower EPS.
A high P/E ratio could be a result of market fluctuations. Therefore, if using a P/E ratio to gauge the stock’s demand, may not necessarily be a good indicator. Investors must ideally avoid using a P/E ratio for stock selection during heavy market fluctuations.
3.Use P/E along with other indicators
While the P/E ratio must definitely be considered by investors while picking stocks, it is best to consider multiple other factors to ensure appropriate stock selection. Some of the factors include the company’s financials, competition, growth prospects, etc.
P/E ratio must be used while bearing in mind that various external factors may have an impact on a stock or company’s performance. Understanding a company’s business, its market presence and competition are some of the factors to be considered while studying P/E ratio for stock selection. For long-term benefits, investors must ensure thorough fundamental research about the company that they plan to invest in.
- What is an ideal P/E ratio?
Different companies may have different P/E ratios. Most companies in India have P/Es ranging between 5-20. However, this range could differ in blue chip companies. Thus, investors must measure a company’s P/E against a benchmark or peer companies.
- How do you know if a stock is overvalued?
P/E ratio is often used by investors to gauge whether a stock is overvalued. Comparing a stock’s P/E to peers is one way to assess this. Investors can also look at market reputation, competition, and business demand, among other factors, to check on stock valuation.
- How often should I check P/E ratio?
While P/E ratios could change daily due to market movements, it is best to check them every quarter when the company’s earnings are released.
- Is it better to buy undervalued or overvalued stocks?
Prices of undervalued stocks may go higher, while those of overvalued stocks may go lower. Investors must pick stocks depending on the P/E ratio and other company fundamentals, apart from considering personal investment strategy.
- Is now a good time to buy stocks?
Irrespective of how markets may be faring, one can buy stocks at any time. This is because stock selection should be based on a fundamental analysis in combination with personal investment strategy.