X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2019 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
P/E ratio simplified - Views on News from Equitymaster

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

P/E ratio simplified

Jul 10, 2008

We thought it would be a good time to write this article as the result season is just about to begin. Also, the understanding of this method could help one take a call on which stock to purchase, hold or sell. Let's start from basics:
P/E ratio: It is one of the basic methods to value a company, on calculating whether it is cheap or expensive at current prices.

P/E ratios are basically of two kinds:

Current P/E multiple - Current market price divided by the trailing twelve months earning per share gives us the current P/E (Price to Earning) ratio. The higher the P/E the more expensive the stock is, and vice versa. It means that an investor is willing to pay a multiple of a certain times for the company's future earnings.

  • Also read - P/E - What is it all about?

    The main reason a stock may have a high P/E is because the company is expected to be a high growth company (so as such the EPS will grow at a fast rate). In certain cases, stocks having exorbitant P/Es could also mean that the company is going through troubled times and as such may have a low EPS. But since the company is expected to bounce back and record high EPS in the future, its current P/E may look unusually high.

    Forward P/E multiple - While current P/E multiple uses the current EPS of the company, the forward P/E multiple, as the name suggests uses the future EPS. The best way of explaining this point would be through an example. If XYZ's stock is trading at Rs 70 and its current EPS (trailing twelve month earnings) is 2, it's trading at a current P/E of 35 times. As mentioned earlier, if a stock is trading at a high P/E rate such as 35, the company is expected to grow at a high pace.

    For this example we'll assume a 30% growth in the profits for the next three years. Assuming the profits grow at the rate of 30% each year, for the next three years, its EPS will reach Rs 4.4 per share in FY11. Thus at the current price of Rs 70 rupees the stock will be valued at 15.9 times in FY11 multiple. Thus, we call it a forward P/E multiple of 15.9 times its FY11 earnings.

    XYZ FY08 FY09 FY10 FY11
    P/E 35.0 26.9 20.7 15.9
    Price 70 70 70 70
    EPS 2.0 2.6 3.4 4.4

    What is an ideal P/E?
    An ideal P/E is a valuation one can give to company's stocks based on certain parameters like their historical valuations, return ratios, future prospects, peer group valuations, industry valuations, future growth potential, management, etc. Ideal P/Es also do vary between companies present in the same sector. For example one would give a higher P/E to a stock like ABB as compared to a stock like Crompton Greaves. The reason mainly would be due to the former's leadership position in its area of business, strong past growth, robust opportunities in the infra space going forward, its parent group support, good return ratios (ROIC, ROCE, RONW), strong and long history of the company and strong balance sheet. We are not saying that Crompton Greaves is a bad company, but in terms of these parameters, ABB scores over it.

    Below is a chart showing an example of a company's past P/E performance. If we look at the P/E multiples of this stock over the past few years, it was trading at a decent (cheap) P/E of around 8.2 times (average) in FY04. Since then the stock has been trading at higher valuations, which could be because of two reasons - the company must have grown at a quick pace (rise in EPS, the denominator hence the price moved accordingly) or investors were ready to pay higher multiples due to high expectations from the company (in the FY06 to FY08 phase).

    One can look at this stock's past P/E multiples and give a suitable P/E band to the stock. But one should also keep in mind the other parameters for this concept.

    We hope that this article will help you in clearing your thoughts on the fundamentals of the P/E ratio and help you make better investing decisions.


  • Equitymaster requests your view! Post a comment on "P/E ratio simplified". Click here!

      

    More Views on News

    BSE Sensex Surges 526 Points; YES BANK Among Top Gainers (Market Updates)

    Jun 20, 2019 | Updated on Jun 20, 2019

    Markets all time high analysis : The BSE Sensex Surged 526 Points; YES BANK Among Top Gainers. Find the latest update, special reports and news on all time high gainers of BSE Sensex at equitymaster.com.

    Should An Equity Mutual Fund Scheme Hold High Cash Balances? (Outside View)

    Jun 20, 2019

    PersonalFN explains whether equity mutual funds hold cash balances.

    Should You Invest In Sundaram Ultra Short-Term Fund For Your Short-term Needs? (Outside View)

    Jun 20, 2019

    PersonalFN briefly shares its views about recently launched debt scheme: Sundaram Ultra Short-Term Fund, an open ended scheme.

    Does Your Stock Pass the Amazon Disruption Test? (The 5 Minute Wrapup)

    Jun 20, 2019

    The great global disruptor of our times has set its eyes on India. Are Indian businesses under threat from Amazon?

    This Little-Known Opportunity Promises Both Health and Wealth for Your Grandchildren (Profit Hunter)

    Jun 20, 2019

    The next big opportunity that has the potential to make you both rich and healthy.

    More Views on News

    Most Popular

    7 Stocks That Will Remain Evergreen in this Era of Technological Disruption(The 5 Minute Wrapup)

    Jun 13, 2019

    We are living in an era of disruption. Are your stocks well equipped to adapt to changes that disruption will bring along?

    The Great Indian NBFC Bubble Has Burst but I Will Still Recommend These Safe NBFCs(The 5 Minute Wrapup)

    Jun 11, 2019

    One chart that predicted the NBFC crisis back in 2016.

    Kenneth Andrade Would Like Our Real Estate Stock Recommendation with Triple Digit Upside(The 5 Minute Wrapup)

    Jun 12, 2019

    This real estate stock recommended in Smart Money Secrets offers the most favourable upside potential.

    Why Modi 2.0 Will Be Great for These 7 Stocks(Profit Hunter)

    Jun 10, 2019

    The government's focus on Infra, electricity, water for all will be the key factors for Sensex 1,00,000.

    Why I Believe Smallcaps Will Catch up to the Sensex(Profit Hunter)

    Jun 14, 2019

    Smallcaps have gone nowhere even as the Sensex makes new all-time highs. Find out why Richa believes this a good opportunity to invest in smallcaps.

    More

    Get the Indian Stock Market's
    Most Profitable Ideas

    How To Beat Sensex Guide 2019
    Get our special report, How to Beat Sensex Nearly 3X Now!
    We will never sell or rent your email id.
    Please read our Terms

    S&P BSE SENSEX


    Jun 20, 2019 (Close)

    MARKET STATS