PE ratio is one of the
most commonly used tool for stock selection. It is calculated by dividing the
current market price of the stock by its earning per share (EPS).
PE Ratio = Current Market
price / Earnings per Share (EPS)
The trailing PE is just
the price per share of the stock divided by the annual net diluted earnings per
share the firm generated in its last fiscal year. The forward PE is the price
per share of the stock divided by next fiscal year’s annual net diluted
earnings per share of the firm. It’s only when investors compare a firm’s share
price to its annual net diluted earnings per share that they can get a sense
for whether a company’s shares are expensive
PE Ratios also differ by
different industries and companies. In most easy terms PE ratio means the completed
annual earnings. If the forward P/E is higher, it means number of years, it
will take for an investor to make back the money invested if the earnings per
share of the company do not grow on a yearly basis. For eg. in the case
of State Bank of India, it would take an investor approximately 15 years to
make back the money, if the earnings per share of the bank do not increase on a
yearly basis. If the forward P/E is lower, that means future earnings are
expected to be higher than the recently the company is expected to earn less
over the coming year than it did in the past year -- not a great sign, in
general.
When a stock trades at excessively high PE ratio say 60 or more, it may be inferred that the investors are greatly excited about the growth prospects of the company. Certain constituents of the investing segment may even be speculators, pushing the market price of the stock skyward. Prudent investor’s should exercise extreme caution and judgment while purchasing stocks at excessively high PE ratios.
When a stock trades at excessively high PE ratio say 60 or more, it may be inferred that the investors are greatly excited about the growth prospects of the company. Certain constituents of the investing segment may even be speculators, pushing the market price of the stock skyward. Prudent investor’s should exercise extreme caution and judgment while purchasing stocks at excessively high PE ratios.
By that logic what if
investors scoop up every low-PE stock thinking that they had found the secret
to perpetual outperformance in the stock market? After all, the market has
practically gone straight up since the lows of 2008, so investors might be
drawn in and associates a low PE with continued strong performance. People who
seek established companies with low P/E ratios are called value investors,
because they’re looking for stocks that have a good value and show every
indication of being steady earners in the short to intermediate term.
Understand that P/Es vary
by industry. Steelmakers, for example, will usually sport seemingly low P/Es,
as will automakers and others, especially those in capital-intensive fields.
Software makers and other "lighter" businesses tend to have higher
P/Es. So don't assume that a steel company with a P/E of 12 is more attractive
than a software maker with a P/E of 25.
The P/E ratio usually looks backwards. If one company is able to double its earnings in a few short years while another remains stagnant, the former could be a much better value despite a higher multiple. Yet you wouldn't know it from the single-snapshot picture the P/E provides. The "forward P/E" is a better tool, because it uses the next year's pro forma earnings instead of last year's earnings. But this picture is still limited since it’s just an educated guess at next year’s earnings. -Remember that accountants can do some creative things with reported earnings. While one company may report a largely honest number, another may be manipulating earnings per share to meet market expectations.
Interpretation of PE ratio is heavily dependent on comparison of the company with its peers. Also PE that is considered very high in certain sectors can be considered very low in other sectors.
For instance, companies in
IT and telecom sectors have higher PE ratio than the companies in manufacturing
or textile sectors.
Also PE ratio is not
totally neutral. Any major announcement of a major order or acquisition by the
company will certainly push up its PE. On the other hand, low PE may not
indicate a good buy but could signify more serious issues facing the company.
So it is very important to perform a thorough research into the background of
the company, before investing.
Besides EPS itself is
assumed, as it forecasts future growth based on past performance. However,
there is no guarantee that the company can continue to maintain its performance
each year. Also the sector in which the company is operating may experience
problems as was recently seen for the IT sector.
So PE ratio cannot be
considered to be a totally reliable indicator of cheap, good stocks.
Yet, PE ratio remains one
of the most important ratios when it comes to stock selection.
There are two kind of PE
ratios:
1. Forward P/E
2. Trailing P/E
Forward P/E is more
important than Trailing P/E because it shows future growth.
