There are several determinants to showcase if a stock is fundamentally strong or not. Financial ratios such as price-to-earnings ratio (P/E), debt-to-equity ratio (D/E), price-to-book ratio (P/B), etc., are helpful in stock valuation. Based on their values, investors can cherry-pick the stocks to buy and get returns.
What is the P/E ratio?
The Price-to-Earnings Ratio is the relationship between the share price of a company’s stocks and its earnings per share (EPS).
P/E ratio = Share Price/Earnings per share
Where EPS= Total earnings of the company/ Total no. of outstanding shares
EPS is a vital indicator of the financial health of a company.
Here’s a brief example to understand the concept:
XYZ Pvt. Ltd. has 5 lakh outstanding shares.
The current market price of each share is Rs. 300.
As per the company’s latest financial performance for a quarter, the company’s earnings were Rs. 50 lakh.
Now, EPS= Rs. 50,00,000 / 5,00,000 = 10
P/E ratio= Rs. 300 / 10 = 30
Based on the industry to which XYZ company belongs, the P/E ratio could be high or low.
What is a high P/E ratio?
As you can see, the XYZ company’s stocks are trading at 30 times earnings. It means investors are paying ₹30 to get ₹1 share in the company’s profits.
High P/E ratio indicates that:
- Investors are highly optimistic about the company
- The company is likely to outperform its peers and competitors
- The company has consistent earnings, profitability, and high return on equity (ROE)
Many investors might feel that it is a good chance to earn capital appreciation along with regular dividend income. However, investing in high P/E stocks should be done while exercising caution.
Things to keep in mind before investing in high P/E stocks
Check share prices and EPS
A company can have a high P/E ratio if:
- a) The stock prices are high
- b) EPS is low
Stock prices can be high due to reasons other than the company’s performance. Keep an eye on them. EPS can drop if a company issues more shares or it has weak earnings in a financial year. In both these cases, EPS will be low; thus P/E ratio will be high.
The stock market is volatile. As a result, it can impact the P/E ratio. Hence, during high volatility, do not assess a stock based on its P/E ratio.
The first rule before investing in the stock market is research. A high P/E ratio should not be the only criteria. Check other company fundamentals such as order book, profit and loss statement, etc., to make an informed decision.
Can you rely solely on this ratio while making investment decisions?
Although the P/E ratio is one of the most commonly used determinants, it should not be a deciding factor for investment. Hence, it is advisable to do thorough research, compare it with industry average, benchmark index, previous value, and factor in other ratios as well.