Price to Earning Ratio – Relevance and Use
Price to Earnings Ratio (PE Ratio) is very popular ratio of Fundamental Analysis. If you want to take a quick view about a stock whether it is cheap or expensive, PE of that stock will give you fair idea.
But by just focusing PE and avoiding other aspects, you should not come to any conclusion that whether a stock is really cheap or highly expansive.
So, in this article we will help you to understand every aspect of PE ratio, so, you can know the relevance and use of PE ratio in valuation of a company.
Let’s start with what is PE Ratio
Price to Earnings (PE) Ratio = Market Price of a Share / Earning per Share (EPS)
EPS is Earning per share a company generates. When current price of a stock is dividend its EPS we get the PE Ratio.
PE ratio denotes how much you are ready to pay to the company for every 1 rupee earned by the company.
For example, if PE of XYZ Ltd is 25, it means Investors are ready to pay Rs.25 for every Rs.1 earned by XYZ Ltd
Now, Thumb Rule for PE Ratio is that if a stock is trading above 25 PE it is considered as expansive.
Where as if it is below 25 then stock is considered as fairly valued and if it is below 10 is it considered as cheap or trading at bargain price.
But, there are some exception to this Thumb Rule
#1 Cyclical Stocks: Cyclical Stocks (such as Auto Stocks & Metal Stocks) trades at lower PE as earning is linked to economic condition in country and in particular industry.
Example Cyclical Stocks are Vedanta, Ashok Leyland, Tata Steel etc.
#2 High Growth Stocks: High Growth Stocks enjoy rich valuations and generally have higher PE. They trade in anticipation of future growth of the company.
Examples are HDFC Life, HDFC AMC, HUL, Avenue Supermart, Info Edge etc.
#3 Inferior Stocks: If any company is facing any fundamental issue or having some serious corporate governance issue then PE of that stock will reflect the same and such companies trade at lower PE compared to the competitor in the same industry.
It is advisable to compare Stock PE with Industry PE to have an idea how other companies are doing in the same industry.
If you find PE of a particular stock below its Industry PE, it can be attractive but better you look point number 3 discussed above that there should not be any fundamental or corporate governance issue.