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Finding "Value for Money" in Stocks (Understanding PE Ratio)
Friends, when we want to invest in the share market, it is very important to find out the rate of the stock, whether the stock is overvalued or undervalued as per its current value. It is very important to find out this. For example, suppose we have a choice of two properties. One property costs you $2.5 million and within that you can get a rent of $10000 per month and the other property costs you $3million and within that you can get a rent of $15000. So, which property would you choose among the two properties? If I talk about the empty value, then naturally, the property worth $3 million I will take it because here by increasing just $0.5 million I am getting extra rent of $5000 from the property worth $2.5 million, which means we are getting more value for money.
Before buying anything it is very important to see the value for money that what value are we getting in the money we are paying. The same concept is used within stock market also, that how much money are we paying for the value of a company which means for the value of a share and what are we getting in it and how is this calculated so it is calculated by PE ratio, i.e. by price earning ratio. So how is PE ratio calculated, how do you know about it You have to interpret this, should you sell high PE or low PE stocks quickly and should you buy them, we will discuss all these things.
How to Calculate the PE Ratio (The Formula)
P/E Ratio = Price per Share/Earnings per Share (EPS)
Price per share is the market price of any stock or share and earnings per share is when you divide the total income or net profit of the company by the total number of shares and you get the earnings per share.
PE Ratio in Action: Comparing Two Stocks
Suppose the current value of a stock price is $150 and its earnings per share comes out to be $10, then we calculate the price to earnings ratio.
P/E Ratio = 150/10
P/E Ratio = 15
So here PE ratio comes out to be 15, so what does 15 mean? 15 means that whatever be the annual income of a company, you are ready to pay 15 times its value today but the question is whether the number 15 is less or more, we will know this only by comparison, so now we have to compare it with its competitors, so let us assume that there is a stock of another company in the same industry whose EPS is 15 and the price is $300, let us find out the PE ratio of this company
P/E ratio = 300/15 = 20
So here our PE ratio is 20, so the PE ratio of the first stock is 15 and the PE ratio of the second stock is 20 and let us assume that the average PE ratio of this industry is 18, so if we compare it, I can say that compared to the industry, the stock with 15 PE is a little cheaper and the stock with 20 PE is a little expensive. I did not say that if 15 PE is cheap then buy it. Here we are not talking about buying decision, we have just found out which stock is cheap and which stock is expensive.
Why Growth Can Matter More Than a "Low PE"
So as we saw in the example of PE Ratio that the stock with 15 is a little cheap and the one with 20 is a little expensive but sometimes you can also buy an expensive stock instead of a cheap one because cheap does not mean that it is a good stock, so here we will understand how to buy the right stock. So suppose there is a company, we see its three years financials, then let's assume that the company's EPS was 10 in the first year, it became 11 in the second year and 12 in the third year, then that company is growing at the rate of 10%, similarly its price was 100 dollars, in the second year it became 110 dollars and in the third year it became 120 dollars, now if we calculate its PE Ratio, then we get the same PE Ratio in all three years which is 10.
Now the question arises that if the price to earning ratio is low then we should buy it. It is not necessary to do so because let's assume that there is another company which has 3 years of financials. In the first year, EPS was 10 and the price was $150, i.e. PE ratio is 15. In the second year, EPS became 20 and the price became $500, i.e. PE ratio is 25. And in the third year, EPS became 40 and the price became $1600, i.e. PE ratio is 40. If the PE ratio of this company is high, then should we not buy it? It is not so. Therefore, we need to understand which company's stock we should buy. For this, first of all we have to look at the growth rate of the company.
The first company is growing at the same EPS every year or at the rate of 10% and its PE ratio is 10. On the other hand, the second company grows twice as much as the first year i.e. 100% and grows 100% in the third year as well and its PE ratio is 40. So here we can see that the growth of a company with a 40 PE ratio justifies its PE ratio i.e. it grows at 100%. Whereas a company with a 10 PE ratio grows at the rate of 10% but does not justify the growth of a company with a 40 PE ratio. So you should buy a stock with a 40 PE ratio considering its growth. Overall, if we understand it in simple words, the growth of the first company is 10% and the PE ratio is 10, then we will divide 10% by 10 and multiply it by 100.
(10%/10) × 100 = 100%
We will do the same thing for the second company whose growth is 100% and PE ratio is 40.
(100%/40) × 100 = 250%
So you should invest in the company which has a higher %, it will give you higher returns. Now let's consider the second company. If the company is not able to grow 100% next year, it grows only 50%, even then its percentage will be more than 100% which is of a company with a PE ratio of 10
(50%/40) × 100 = 119%
So now even at 119% this company is giving you more value than the first company, so now you must have known what you should look for before investing in a company
About the Author: Abhishek Lohar
B.Com Graduate and the Founder of Free Online Financial Calculator. I specialize in simplifying complex financial calculations and investment strategies. My mission is to ensure you can make confident financial decisions using our research-backed content and accurate calculators.
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Disclaimer: The information provided in this article is for educational purposes only and should not be considered financial advice. Please consult with a qualified professional before making any investment decisions.