Guys, today this post will cover the PE ratio in context to stocks and we will try to understand the real meaning of it.
It is the price to earnings ratio and is heavily used for valuation analysis of an asset like stocks etc.
Common terminology behind PE ratio
When PE ratio is high compared to the industry average, a stock is termed as overvalued and when it is low or equal to the industry average, the stock is termed as undervalued or fully valued.
Say PE ratio for a stock ABC is 15. It means buyers are willing to pay Rs 15 for Rs 1 earning of the ABC. For an example, someone who buys an asset like stock definitely wants to earn a profit. But when an individual buys a stock at high PE he takes a risk and wants a buyer who is willing to pay a higher price for the same stock. If other buyers are not willing to pay a higher price then definitely one has to sell at lower price and book a loss.
What does high PE of stock signify?
- It tells that market is willing to pay a high price for the stock in spite of its low earnings.
- The market expects higher growth in high PE stock compared to low PE stock.
- One can also expect overvaluation of the stock if in future there is no growth in earnings.
- There are very high chances that law of revision to mean will occur which states either stock earning has to grow in future or else stock price will start to fall.
- PE cannot increase forever.
Do we have a relative PE which could be used as a baseline?
No, there are various sectors like FMCG where presently market is willing to pay more and expect high growth, therefore we can see 100+ PE. But there are some sectors which are saturated and the market doesn’t seem to pay much for them. The sectors do not expect higher growth and are likely to the same set of sales and profit growth. Some of the examples include Oil exploration (Deep Industries) and marketing companies (IOCL) have an average PE of 12.
When should we buy a stock?
Buying and valuing a stock is not so easy as everyone understands. If a stock is trading at low PE that doesn’t make it a value buy. We should understand and look for a possible reason why the stock is trading at low PE.
Some of the possible reasons for low PE
- The company has posted fall in Quarterly results. It happened with a lot of pharma companies (Glenmark) in 2017 when they posted losses due to the devaluation of rupee and USFDA observations.
- There has been some management change in company and market is expecting growth of company could be in danger. It happened in Pincon Spirits where a management personnel was arrested for syphoning the money.
- There have been some government policy changes or action which caused the business to poorly perform. It happened in case of Satin Creditcare, business faced losses due to demonetization.
- The company has taken a lot of debt and now interest coverage ratio has declined significantly. It happened with RCOM where they defaulted on payment of interest and stock declined to 20% in a day.
But do a low PE makes a company undervalued.
It depends on the situation to situation. One has to estimate that is the company really in danger of bad performance or it is just a temporary phenomenon. In some of the cases, the sharp decline in price is not justified and an investor can jump in to make a good bargain of the company.