Why Are PE Ratios Important In Picking Stocks To Invest?

While reading technical reports or brokerage review reports, you may have come across the term "PE ratio" and wondered what it means.

It is part of the "fundamental analysis" of a stock.

If you looking to invest in a business, by invest we mean long-term (3 to 5 years at least) commitment of funds to a company, you will have to ignore the noise around temporary changes in stock prices and rather focus on the performance of the company, including how its management is working on creating wealth for its investors in the future.

A fundamentally sound company will create value for its investors over time and the shares of its company will appreciate in value.

Financial ratios

One of the aspects of financial analysis is financial ratios. Financial ratios help in interpreting the financial results of the company and compare its performance with the previous years and also with other companies in the same industry.

Within these ratios is a category called "valuation ratios" which are used to compare the "worth" of a company's stock.

A determining on how much profit you make on a stock investment, the buying price is as important as the selling price.

With the help of valuation ratios, you can get an idea of whether or not a business has been overpriced. Valuations dictate the price you pay to acquire shares of a business.

PE ratio

Price to Earnings (PE) ratio, is one of the most popular financial ratios. It is commonly used to determine if a stock is overpriced.

PE ratio = Current price of the stock/ EPS

EPS here means Earnings Per Share, which in simple words means net profit per share. It divides net earnings with average outstanding shares and is used to measure the profitability of a company on a per-share basis.

For obvious reasons, the higher the EPS, the better it is for shareholders.

Now, if you were to divide the current market price with the EPS (which gives you the PE ratio), you will be able to measure the willingness of the market to pay for every rupee of profit that the company generates. For example, if the PE ratio is 10, the market is ready to pay 10 times the profit the company makes.

In the case of PE ratio, the lower the PE ratio, the cheaper the stock is for the buyer.

You can use both EPS and PE ratio to compare two stocks within the same industry to make a more informed choice in your purchase.

2 types of EPS

Analysts use two types of EPS: Forward EPS and trailing 12 months EPS.

The first is used to construct a proforma or future projection for analysis while the second is based on historical actual data and it is used for comparative analysis.

How to use PE ratio for analysis?

In general, the PE ratio is used by analysts and investors to compare the performance of a stock with its peers. It a measure to determine the amount an investor has to invest to receive a unit of the company's earnings.

Each industry has a benchmark PE that you can use to judge if the stock is undervalued, overvalued or fairly valued.

Things to remember

• It is not advisable to buy stocks with high PE ratios, which means that the stock is overvalued since if and when the stock falls, it could destroy your wealth to the point of no recovery.
• If the PE ratio is too high, it is either because the stock price is too high or the earnings made by the company is too low. Together, a high share price and low profit can cause a double whammy effect of very high PE ratio.
• There are times when if the shares of a company are fairly priced (or stable) and there is a sudden fall in a company's earnings due to unusual circumstances (like lockdown), the PE ratio could go up. It could mean that the market has not yet adjusted to the price linked to the performance of the stock and the stock could eventually fall, causing you to lose money.
• The stock price of a company (the numerator) often climbs when the expectations of earnings from the business increases. However, earnings (denominator) can be manipulated. One way the company can manipulate earnings is by changing its accounting policies too often. Even lesser depreciation accounted for on assets can boost earnings. If the company's earnings are increasing without an increase in its cash flows and sales, the earnings are being manipulated.

About the author

Olga Robert is an M.Com graduate covering equity markets and personal finance for nearly three years. Her interests include tax planning, equities, DIY personal finance management and government schemes.