If you are new to stock trading, you may be wondering what the P/E ratio is. And why it is considered while purchasing stocks. This blog is intended to give you a brief understanding of the P/E ratio.
As a stock market trading investor, you always want to buy undervalued or low P/E ratio stocks.
Trying to understand the reason behind this concept will be helpful to get an idea of what the P/E ratio is and how it works.
As defined, the "Price to Earnings Ratio" or P/E ratio is a valuation indicator that measures the number of money investors pay for each dollar of a corporation's earnings.
It is calculated by dividing the current market price by its earnings per share (EPS).
The P/E ratio can also be stated as "how much an investor pays for one Rupee of earnings".
It gives valuation multiple times higher or lower than the market average. The lower the number, the better the bargain.
So why should you prefer low P/E ratio stocks? To answer this question, we need first to understand how it works.
How does the P/E ratio work?
Low P/E ratio stocks can be considered as blue-chip companies. These are the companies considered to be leaders in their respective fields. They are well established, have a long history and reputation, and have a loyal customer base.
So why should you prefer low P/E ratio stocks?
To answer this question, we need first to understand how it works.
P/E = Price/Earnings Ratio
The P/E ratio is the most commonly used metric for valuing stocks. It's calculated by dividing the market price per share by earnings per share (EPS).
The lower the P/E ratio, the better it is for investors because it means you get more earnings per Rupee spent.
For example, if a company has a P/E ratio of 10, it means you have paid Rs 10 to buy Rs 1 worth of profits (earnings).
Whereas if a company has a P/E ratio of 20, you will have to pay Rs 20 to buy Rs 1 worth of profit. 20 is higher than 10, and hence the former company offers lower value.
Low P/E Stocks = Low-Risk Investment
Now that we know how the P/E ratio works, let's quickly jump into the factors to invest in Low P/E stocks.
Consideration Factors to Buy Low P/E Ratio Stocks
A low P/E ratio could well be a valuation call; it could be a call on the quality of the business.
It is essential to know the reasons for a low P/E ratio before investing in such companies.
If the company is bad, avoiding such companies would be a smart move.
On the other hand, if it is because the market has doubts regarding the future performance of the company, then you must make an independent analysis based on facts before you decide to avoid them or not.
Another example is of Nifty midcap stocks. If you look at the P/E ratios of the NSE Midcap Index and Nifty Smallcap index, you will find that the NSE Midcap index has consistently traded at a lower P/E ratio than the small caps.
The reason for this is straightforward – it is because investors perceive that midcaps are riskier than small caps.
So, a low P/E ratio can be a warning sign, but the P/E ratio cannot use it in isolation to judge companies.
Before forming an opinion on a company, you need to look at other factors like return on equity, interest coverage ratio, debt levels and more.
(Read more about - Factors to be Considered While Choosing Ideal Stocks )
If not P/E, then what should one look at?
There are things you can look at. You can look at the return on equity, which measures profitability. You can look at book value, which measures assets relative to debt.
You can look at the profit margin, which is how much profit you're making relative to sales. And you can look at growth rates.
Some companies have very high P/E's and are also doing extremely well in profitability, asset turnover, and financial risk.
Those things tend to be overlooked as people focus on the P/E ratio alone.
The best way to figure out what's going on with a company is to go through that exercise of looking at all the different factors and then coming up with an overall assessment.
Now, we don't want to say there's no place for the P/E ratio because it tells you something about how expensive stocks are in general.
Still, it doesn't tell you anything about whether a company is cheap or expensive relative to its history or its competitors or its growth rate or its prospects."
Conclusion
Wrapping up, we conclude that you should consider P/E with the combination of factors before buying a Stock, like Return on equity, Asset relative to debt, profit margin etc.
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