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Demystified: How to use PE
ratio to value a stock
The PE ratio is probably the most common measure to help
investors compare how cheap or expensive a firms shares
are, as stock prices, for lack of a better term, are arbitrary.
The trailing PE is just the price per share of the stock divided
by the annual net diluted earnings per share the firm generated
in its last fiscal year. The forward PE is the price per share of
the stock divided by next fiscal years annual net diluted
earnings per share of the firm. Its only when investors
compare a firms share price to its annual net diluted earnings
per share that they can get a sense for whether a companys
shares are expensive (overvalued, overpriced) or cheap
(undervalued, underpriced). The higher the PE, the more expensive the companys stock--all
else equal.
During bear markets, stocks generally trade at lower PE multiples and during bull markets at
higher levels in relation to historical values. It is prudent for the investor not to pay excessively
high PE ratios for securities in reference to historical values. When stocks trade at historically
high PE ratios it could be a tell tale sign of an imminent bear market.
PE Ratios also differ by different industries and companies. In most easy terms PE ratio
means the number of years, it will take for an investor to make back the money invested if the
earnings per share of the company do not grow on a yearly basis. For eg. in the case of State
Bank of India, it would take an investor approximately 15 years to make back the money, if the
earnings per share of the bank do not increase on a yearly basis.If the forward P/E is lower,
that means future earnings are expected to be higher than the recently completed annual
earnings. If the forward P/E is higher, it means the company is expected to earn less over the
coming year than it did in the past year -- not a great sign, in general.
When a stock trades at excessively high PE ratio say 60 or more, it may be inferred that the
investors are greatly excited about the growth prospects of the company. Certain constituents
of the investing segment may even be speculators, pushing the market price of the stock
skyward. Prudent investors should exercise extreme caution and judgment while purchasing
stocks at excessively high PE ratios.
By that logic what if investors scoop up every low-PE stock thinking that they had found the
secret to perpetual outperformance in the stock market? After all, the market has practically
gone straight up since the lows of 2008, so investors might be drawn in and associate a low
PE with continued strong performance.People who seek established companies with low P/E
ratios are called value investors, because theyre looking for stocks that have a good value and
show every indication of being steady earners in the short to intermediate term.
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6/30/2014 Demystified: How to use PE ratio to value a stock - Moneycontrol.com
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In this latest bull market and period of new IPOs, there are a lot of fund managers and analysts
clamoring about where a stock is selling or its multiple. And they all act as if this number is
the end-all be-all.If you find a company with a low P/E, try to determine why it's low. See
whether the company has encountered any problems recently, and determine whether those
problems will likely be temporary or permanent. Many lenders, for example, are being
pressured by issues surrounding NPAs these days.
Understand that P/Es vary by industry. Steelmakers, for example, will usually sport seemingly
low P/Es, as will automakers and others, especially those in capital-intensive fields. Software
makers and other "lighter" businesses tend to have higher P/Es. So don't assume that a steel
company with a P/E of 12 is more attractive than a software maker with a P/E of 25.
But P/E paints an incomplete picture, and heres why:
-The P/E ratio usually looks backwards. If one company is able to double its earnings in a few
short years while another remains stagnant, the former could be a much better value despite a
higher multiple. Yet you wouldn't know it from the single-snapshot picture the P/E provides.
-The "forward P/E" is a better tool, because it uses the next year's pro forma earnings instead
of last year's earnings. But this picture is still limited since its just an educated guess at next
years earnings.
-Remember that accountants can do some creative things with reported earnings. While one
company may report a largely honest number, another may be manipulating earnings per
share to meet market expectations.
P/Es need to be placed in a context that gives them meaning in which theyre compared to
competitive companies or to an industry average. And maybe most importantly, the P/E ratio
should never be the only metric used when trying to determine whether a company is currently
overvalued or undervalued. It doesnt matter if its a trailing or a forward P/E. No ratio should be
used in isolation for that matter. The P/E becomes more useful if you can get a grasp on just
how much in earnings a company will be able to achieve over the coming years. But in order
to do this, you'll need to study the underlying business and understand its margins, scalability
and competitive position within the industry.
So long story short, the P/E is a helpful metric. But dont make the common amateur mistake
of letting it be an end-all, be-all valuation metric.
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