One of the basic fundamental ratios to analyze whether a share is worth buying and is undervalued is to look at the price to earnings ratio or p/e ratio.

Price to earnings ratio is arrived at by dividing the EPS by the current market price. Read how to calculate and what is p/e ratio

Why P/E ratio is not the best way to analyse a share?

On the other hand PSU banking shares are trading at a p/e of just 6-7 times. Now, if they are trading at such low p/e does it make them attractive buys because they are cheaper.

The answer is probably not. The reason for them are plenty and let's examine them.
Markets look at growth prospects

The future growth potential is of utmost importance to markets. So, if pharma companies are growing at 20-40 per cent, the markets are prepared to pay a hefty premium for them, which is why some pharma shares like Dr Reddys, Glenmark Pharma and Sun Pharma trade at ridiculously high p/e levels.

On the other hand individuals are not ready to buy government banking shares despite a low p/e multiple because of problems with growth, asset quality etc.

Management

Individuals also look at the quality of management and may accord a premium in terms of price to earnings multiples for quality management and companies that are professionally run.

Innovation

Investors would look at future growth through innovation and ingenuity, which is why pharma companies have an edge.

Compare peer within the industry

Some investors tend to compare price to earnings ration of peers within the industry. But, here again one must keep in mind that a company that has expansion plans, a quality management, brand equity and solid track record will command a higher price to earnings ratio.

Therefore, one cannot look at this ratio in isolation.

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