Price-earning ratio or P/E ratio is a very common tool often used by investors while taking investment decisions. The ratio of market price to earnings per share is known as P/E ratio. For example, if the market price of a company’s share is Rs. 100 and the company’s earning per share (EPS) is Rs. 2, its P/E ratio will be Rs. 50 (100/ 2). There are two different thoughts on the ratio. As per one thought, lower the ratio, better it is. This is because, if the ratio is low, then it will give a fair chance to the investors to earn through appreciation in the price of the share, i.e. the chances of capital yield will be high. However, the second thought is exactly opposite to the first one.
Now, a query which investors usually enquire is the period for which the earning per share is taken into consideration. The answer is, you can either take it for the complete year or you may take it for the last quarters. If the exact figures are not available, then you can even consider the estimated values of earnings that you expect in next few quarters.
Use of P/E ratio
P/E ratio is used for different purposes. It is also used to calculate how much in general investors are willing to pay against per rupee of earnings. Despite the clashes in the two thoughts for P/E ratio, in general, a high ratio is considered as a good sign as it indicates a high earnings (high capital yield) in future. The investors who are willing to hold the stock beyond a year and are more interested in capital yield rather than current yield (current yield stands for dividend for the year), are actually more interested in investing in high P/E stocks. But it should always be remembered that just by looking at P/E ratio of a stock, you should not take your final decision of investment in the stock as the ratio is not complete in itself. The ratio is more useful when an investor compares the stock with other stocks in the same industry. One can also compare the P/E ratio of a company’s stock with its historical P/E ratios.
Risks of using P/E ratio and risks of buying stocks with high P/E ratio
Now, the question arises that what does a high P/E ratio actually indicates. The logic is very simple, a high P/E ratio indicates that the investor will actually be paying more to get an estimated stream of earnings. The next question should be that why anyone will be paying more when one can get the same level of current earnings from stocks of other companies. People usually pay more only for those companies which they expect will grow faster in comparison to other companies. So the detriment which they incur by paying more on that stock can be compensated by earning a high capital yield. These are those shares which the investors would like to hold for a longer period in anticipation of appreciation in their market value. If the expectation of growth in the company meets the reality, the investor will gain. However, in the reverse situation, the chance of loss to the investors is also high. For example – if the market price of the share is Rs. 250 and the P/E ratio for a stock falls from 50 to 25 and the company managed to maintain the earning per share at Rs. 5, this means that the price of the share will fall to Rs. 125. That is, even when the company is in profits and earning per share is maintained at Rs. 5, the investor has lost in terms of capital depreciation as the market price of the share has reduced to Rs. 125.
Special feature of stocks with high P/E ratio
If you will look at the stock values, then on usual basis, you will find that the stocks with high P/E ratio are more expensive than the stocks with low P/E ratio. In addition, stocks with high P/E ratio are often growth stocks, i.e. it is believed that the stocks will grow faster than the average. For this reason, P/E ratio is also used as a yardstick to measure whether the stock is overvalued, undervalued or is priced at fair value.
