What Every Stock Investor Must Know About PE Ratio 

Why PE or price earnings ratio is such an important indicator of a stock for a stock market investor? What is it and how to decode it.

Edited transcripts

UDAYAN RAY In this particular segment we will be talking about trying to demystify one of the terms that is used very, very often. That’s the PE. PE is price earnings ratio. Now what is this all about and why do people keep talking about it? We will try to decode it in very, very simple terms for you. That’s coming up shortly.
Now PE or price earnings ratio is something that people in any stock market discussion or any discussion about stocks. What is this term all about and why does it hold any kind of importance for an investor whether it’s a prospective investor or an existing investor? To help us understand this and decode this term, we have with us stock market expert Mohit Satyanand. Hi Mohit!

MOHIT SATYANAND Hi Udayan!

UDAYAN RAY Mohit PE ratio is an oft used term. For a lay investor, can you explain it in simple terms? Why should an investor be worried about it?

MOHIT SATYANAND I wouldn’t say worried, but I think it’s the most important single metric of relating to a stock. So first earnings: Earnings is a reason I own a stock, and price is how much I am willing to pay for that. So let’s take two hypothetical companies which are identical in all respects.

They are both growing at the same rate. And they both have earnings of Rs 1 per share each. But the share of one company is priced at Rs 10 and the other at Rs 50. Which would I buy? Obviously, I would buy the share which is available at Rs 10. Meaning it has a PE ratio of 10:1. For a Rs 1 earning, I am paying a price of Rs 10. That’s a PE of 10. But the other one for the same earnings, the same prospect of earnings growth, I am paying Rs 50. It’s much more expensive. So this PE ratio is actually compressing a whole lot of information about a stock into this one number. What is it making today and what am I paying for that earnings?

Of course you don’t buy a stock for what it’s earning today. You buy it for what you expect it to earn. But in the absence of other data, what it’s earning today, last quarter or last 12 quarters, or last 4 quarters, the last running year, becomes a sort of a surrogate or a short hand for what I expect the company to earn. And therefore this PE Ratio is the single most important ratio. And we use it not just to look at a company but we use it to look at an entire stock market. So for example people say today that the PE ratio for the Nifty is close to its all time high, and therefore we should be careful about investing in the Nifty. And I think this is probably a good place to insert one more thought which is that if I had two companies, both of which were available for the same PE, let’s say 10, but one company has been growing at 10% per annum, and another company has been growing at 40% per annum. Which would I rather buy? Obviously I would much rather buy the shares of the company which is growing more and more rapidly. Because, then over a period of time, one company will have earnings only grown by 50% over a 4 year period; the other would have more than doubled. And therefore at that point in time the PE ratios of the two will be very, very different. And this is where you bring in another allied concept of PE growth.

UDAYAN RAY PEG Ratio.

MOHIT SATYANAND PEG Ratio. So I don’t want to get into that. I am making a simple point that (a) the PE ratio is extremely important (b) the growth (of PE) is very important.

UDAYAN RAY Mohit a lot of people talk about forward PE ratio, this and that. That is basically to figure out what you are earning today how it will pan out tomorrow.

MOHIT SATYANAND Right

UDAYAN RAY Is there any smart and accurate way of doing that or it’s a subjective thing? Anybody can do anything they want.

MOHIT SATYANAND There is no accurate way and there is no fail safe way, because nobody has seen tomorrow. But it’s more about feel. Is this sector growing? So, is the purchase of cars growing in our country or not? Is it growing at 5% per annum or 10% per annum or 20% per annum? Within the car market is Maruti doing well or Hyundai is doing well or Ford is doing well? I think these are good and very useful ways of looking at a company. And that is what analysts do.

UDAYAN RAY Fair enough. So one thing that comes out when you are looking at a PE ratio, these are some of the things that a price earnings ratio will typically tell you. And that’s what you need to be looking at. These are some of the things that it tells you and these are some of the things that you should be looking at.