What is PE ratio?
PE is called the price to earnings ratio and is one of the most important financial parameters to value a stock. That might sound very technical, so let us understand this with a simple example.
You need to arrive at the EPS first...
The price to earnings ratio is nothing but the EPS divided by the current market price of a stock. While we know what the market price would be, how do you arrive at the EPS.
Earnings per share is nothing, but, the net profits of a company divided by the number of shares of a company.
So, if the EPS of the same Company A is Rs 10 and the stock price is Rs 100, we say that the p/e is 10. Now, if company B from the same industry has an EPS of Rs 8 and the stock price is Rs 96, we say that the p/e is 12 (96 divided by 8). Now if an analyst is looking to buy stock A and B he will realize that B is more highly priced because it enjoys a p/e of 12, so he might choose to buy stock A, which has a p/e of only 10.
However, stock A maybe cheaper for a whole lot of reasons, so you need not look at only p/e in isolation. For example, in the banking sector HDFC Bank enjoys a very high p/e multiple because its non performing assets are very low, and the bank reports net profit growth that are way above industry estimates. ICICI Bank enjoys a lower p/e multiple, because its quality of assets is not as good as HDFC Bank.
This is why p/e may not be the only factor to look at when buying shares. One needs to look at future growth, oustandanding debt, technical aspects like market price and moving averages, pledged shares of promoters, book value of shares etc. In short, a whole lot of other things.