PE Ratio is one of the most overlooked by novice investor and sought after and studied by experienced investors of a company’s stock since ages.
PE Ratio gives an idea on whether the stock price is undervalued or over valued at a given time.
Most of the times when a stock is overvalued it falls and if undervalued it goes up.
PE Ratio is just one of the indicators to invest in stocks, there are others as well but PE Ratio is a very important indicator.
Let say you are undecided to buy shares between two companies in the same business field, then PE Ratio is the best indicator to look at before buying share of a company.
PE Ratio gives an indication whether current price is justified to buy the stock or not.
How Is PE Calculated?
PE is calculated by dividing the current market price of the stock by its Earning Per Share (EPS). It shows the sum of money you are ready to pay for each rupee worth of the earnings of the company.
PE = Market price / EPS
Let us assume there are two companies XYZ and ABC both in the IT sector and have almost same services, products, pricing of services & products, financials, infrastructure, debt etc. In that case how to decide which company share to buy?
Here is where PE ratio helps.
Let us take example of Wipro and Infosys – both are Information technology consulting company. Assuming Laxmi wants to buy either Wipro or Infosys as a long term investment but is undecided which company to pick. Both company looks good in future, so she decided to look at the stock’s PE ratio.
She gets Wipro stock PE from moneycontrol.com site here:
WIPRO EPS (Rs.) 33.61 as of Mar 2017.
WIPRO PE = 285/33.61 = 8.47
Then checks Infosys stock PE from moneycontrol.com site here:
INFOSYS EPS (Rs.) 60.16 as of Mar 2017.
INFOSYS PE = 902/60.16 = 14.99
If you are comparing two stocks then the stock with lower PE ratio is a better buy as the market price has not gone up to reveal the earnings prospects of the company. However this does not mean that the higher PE company has no growth prospects, it may have better growth prospects but still there are chances that the company stock with lower PE may generate better returns in near future than a company stock with higher PE in the same sector.
This means Laxmi will buy WIPRO stocks as it has lower PE 8.47. than INFOSYS 14.99.
PE can be very high in certain sectors, and can be very low in other sectors. Therefore PE comparison is important in the same sector business. Any major announcement of a major order or acquisition by the company will push up its PE. You need to keep this in mind while calculating PE.
Note: PE ratio cannot be considered to be a totally reliable indicator of cheap, good stocks. In future the company may not perform as expected and the share price may fall. Still, PE ratio remains one of the most important ratios when it comes to stock selection.
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