When it comes to a serious consideration of terms and strategies took into account in the share market, I think “P/E Ratio” is the one of the most talked about. Every one keeps a close eye on it as it defines whether the share is expensive or not. So, in today’s article, I shall explain what is P/E ratio and how one can use it in a fruitful way.
The “P” in “P/E Ratio” stands for the “Price” and “E” stands for the “Earning”. So, it is the ratio of price and earning. The Investopedia explains P/E as:
‘The “multiple”, because it shows how much investors are willing to pay per dollar of earnings. If a company were currently trading at a multiple (P/E) of 20, the interpretation is that an investor is willing to pay $20 for $1 of current earnings’
Its pretty clear from above definition that P/E Ratio refers to the price we pay for the 1 Rs. earning (as my audience is Indian so, i would like to put all figures in Indian Currency). For a company which is fairly priced, its P/E ratio should be equal to its earning growth rate. You can easily find out the growth rate earning by checking earning per share (EPS) of each year. If a company X has P/E ratio equals to 16 and you expect the company to be growing at about 16 percent a year then the company is fairly priced. But if the P/E ratio is less than the growth rate, you may have found a bargain. Let say company Y has a P/E ratio of 7 and it is growing at 14% an year then it has a very attractive prospect. On the other hand, if company is growing at 7% an year with P/E ratio of 14 then it has an unattractive prospect.
So, one can surely figure out if the P/E Ratio is half of the growth rate; the company has great potential. Similarly if the P/E Ratio is double of the growth rate; the company has very negative prospect. One can use this measure to analyze the share.
Peter Lynch in his book named ‘One Up On Wall Street‘ explained a slightly complicated formula in regards to this. Formula in pure mathematical terms will be –
(Long Term Growth Rate + Dividend Yield)/(P/E Ratio)
- If this figure is less than 1, company’s prospect is poor.
- If this figure is 1.5, company’s prospect is okay.
- If this figure is 2 or more than 2; it signifies that you have found the share which you were looking for.
For example, if company’s growth rate is 16% an year with a 2% dividend yield and P/E Ratio equals to 6. Then, according to above formula the number for the company will be 3 and its a good number.
With the P/E Ratio there are other factors also which we need to take care of, but its the most basic factor which one looks at his first glance and then come the others in line.
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Happy Investing!!
