PE ratio: An Indicator of Overvalued or Undervalued Stocks?
When you want to invest in Stock Market it is very important to know the right price of a Share. If you know a share is Overvalued or Undervalued then you can make decision to pick that share or not. Basically there are 2 aspects based on which the decision made whether to go for a stock of any company- First is Fundamentals of the company and second is Valuation of the company. In this article, we focus on second aspect i.e. Valuation. We will see how we can determine that a share is cheap or expensive at a particular moment. Currently, share price of MRF is Rs. 87500 while its competitor CEAT share price is Rs. 1750.If you think MRF is expensive, it is wrong. To compare share prices, we need to bring them in same platform and that’s where we use PE ratio to know real value of a share. Let’s understand PE ratio in detail-
What is PE ratio: It is Price to Earnings ratio, when the Share price of a company per share is divided by its Earnings per share then it gives the PE ratio. To calculate PE of a company, first you need to calculate Earnings per share i.e. EPS. Earnings are nothing but PAT i.e. Profit After Tax. So the following formulae are used to calculate PE of any company:
EPS= PAT/ Total no. of shares
PE= Market price per share/ EPS
Market price you can get from NSE/BSE or any other financial website while PAT and total no. of shares you can find in company’s annual reports. Well there are many platforms where you can directly get PE of all companies with all historical and also with its peers data. You only need to analyse that data in order to go for stock picking.
Why PE ratio is so important: There are mainly 4 reasons which makes PE ratio extremely important in Valuation of the share of a company-
- PE ratio’s first component is Share Price- you invest in market to make money so obviously the most important for an investor is Share price and its change.
- Its second component is – Earnings or Profit of the company, when you are interested in a company, the bottom line of investing is Profit. If company makes profit then only you expect to gain by investing in it.
- PE brings all competitors of an Industry at one platform, so that investor can compare them and make his/her decision.
- It is widely used parameter in Valuation of a company and its share price.
Interpretation of PE ratio: If a company’s Share price is Rs. 120 and its Earnings per share is Rs. 5 then its PE ratio is 120/5 = 24. It is interpreted as- Investors are ready to pay Rs. 24 for every Re. 1 of earning of the company. In simple words, in order to earn Re. 1 a investor is ready to pay Rs. 24 for that share. You can also understand it with this analogy, you want to buy a flat at market price of Rs. 30 Lakh and you will get rent of Rs. 15000 if you rent it. So you are ready to pay Rs. 30 Lakh to earn Rs. 15000 monthly and hence PE in this situation is 30 lakh/15000 = 200 (on monthly earnings). The investment which you made to earn is actually PE ratio in stock market.
How to use PE ratio to determine a share is overvalued or undervalued: PE ratio of a company is compared with its peers or with Industry average. If PE ratio of a company is less as compared to PE of its peer companies then share is considered as undervalued and if it is high then it is considered as overvalued. In above example of MRF and CEAT, MRF price is Rs. 84500 and its PE is 64 while CEAT price is Rs. 1150 and its PE is 312, so as per PE ratio CEAT is far more expensive than MRF. In this way you can get an idea about the value of a share of any company.
How to check PE ratio: There is a lot past data available for a company so it is important for you to know which PE values you should consider for your analysis. Usually you should consider the PE of last one year to gauge the performance of the share price. Prices of shares change on daily basis while Earnings figures come quarterly so PE also changes on daily basis due to change in numerator on daily basis. You can compare PE from past 3 years and find the median PE and compare it with current PE. You should also compare PE from its peers and Industry average. If PE is lower from its own historic data, with its peers and with industry average, chances are that this share is showing a Good BUY.
Understanding PE ratio with example: All PE and related data is readily available on online platforms like screener.in, moneycontrol.com etc. You don’t have to calculate PE on your own. Let’s understand PE and its valuation from one real example- INFOSYS.
The current Infosys Share price is- Rs.1594 while its PE is 30.09 and hence investors are ready to pay 30 times of its earnings for its share. Is it at premium or discounted price? For that we need to compare it with its peers and its Industry average. Its peers PE are: TCS- 31.77, HCL technologies- 26.96 Tech Mahindra- 23.52 and WIPRO- 17.48 and Industry average is 26. On PE comparison WIPRO seems to be undervalued and TCS seems to be overvalued on PE parameter.
Word of caution: PE ratio is NOT only parameter you need to check, there are many other parameters for Fundamentals and Valuation of a company. So just by relying only on PE that if PE is low you buy and PE is high you don’t buy; is not the right way. Just like PE you need to give importance to each and every parameter.
Conclusion: Though PE ratio gives a fair idea but it does not put the complete picture of Valuation. In stock market no ONE single parameter or indicator can give you full picture. As a good investor you should analyse 360 degree prospects before making any decision. Happy Investing.
