In the last blog we talked about P/B ratio of a company. In this blog we are gonna talk about the P/E ratio of a company. How it is useful in analyzing a company and with help of this ratio how you can find some good stocks to invest. To understand P/E ratio of a company we must first understand E in it which demonstrates Earning per share of a company.
Earning per share
Earning per share is nothing but how much company earns per year divided by no of shares. Lets take an example to understand this.
- If you have a shop which earns Rs 100 in a year and you have 4 partners in it.
- So Earning per share will be 100/4 = Rs 25.
- So EPS of that shop will Rs 25.
Now price is the CMP(Current market price) of the company.
So P/E is Price to earning per share. Lets take Reliance Industries to understand it.
If you look at the EPS of Reliance industries it is around Rs 58.20. What it mean? It means Reliance Industries earns Rs 58.20 per share in a year. Now if you look at the P/E ratio of Reliance Industries it is around 24.2. This means that are you are paying 24 times the amount Reliance Industries earns for you per year. Let me get it simple. Just take out your calculator and multiply 24 X 58. You will get the Current market price of the company.
Now let me ask you question? Will you pay Rs 70 for a shop that earns Rs 1 per year. Think about it. What I am trying to say is High PE is not good. You should look for low P.E company. This is just a measure to check how much amount you are paying for that company that earns some Rs X amount for you in a year.
Now you will think this is so easy, let me list out some companies which have low P.E and invest in it. NO!!!!!! This is not that simple. Low P.E doesn’t mean that company is good for investing. Lets take an example to understand this.
Company Earning per year Current market price
Company A Rs 100 Rs 1,000
Company B Rs 100 Rs 2,000
Profit in years 1st Year 2nd year 3rd year
Company A 80 90 100
Company B 20 50 100
If you calculate the P/E ratio of both company, Company A has P/E of 10 while company B has P/E 20. Now you will think Company A is better than B since the P.E is less but take look at the profits they are generating year on year basis.
- Company A profits is increasing by 10% each year.
- Company B profits is increasing on an average 30-40%.
This is the reason why the market is giving high P/E to company B rather Company A. Still didn’t get it ? Lets take a example why is it happening so.
- You purchase a stock at Rs 100 and EPS is at Rs 5 that so P/E is 20.
- Next year EPS increases to Rs 10 so now the P/E is 10 right?
- Next year EPS increases to Rs 20 so now the P/E is 5 right?
- You wanted a low P/E company ? There it is .
- Since you purchased the stock at Rs 100 that cannot be changed right? given the condition you don’t average it.
- So Year on Year EPS is increasing and price is same at Rs 100 hence you get low P/E company.
So thats the reason why the market was giving a higher P/E to the company B rather than A because the future earning as predicted will get increased and hence EPS. So in future even if you purchased the stock at high P/E it will get reduced in upcoming years if the company is generating more profits. I hope you got my point.
There is a situation where you may get cheated in P/E ratio is Real Estate sector. A builder will have a situation where he may sell 500 flats in year so the profits may go up and hence the EPS and as the P/E ratio may get reduced over time. You will think it of as a cheap company with low valuation but next year he doesn’t sold any flat what then? EPS will go down and hence P/E ratio increases.
Whenever you are looking for a P/E ratio – look for the industries where it may increase little by little like FMCG, Pharma etc. Not for the Real Estate Sector since it is a volatile market.