Updated: Jun 29, 2021
Before getting into the controversy let’s begin our discussion with the fact, what is the price-to-earnings ratio (p/e)?
The P/E is one of the most used valuation parameters which helps us to decide whether the preferred stock is overvalued or undervalued.
If we go by the definition provided in the text-books “how much an investor is willing to pay for per rupee earnings of a company”. What does it convey to a layman?
Well, first we’ll look into the formula of P/E:
P/E ratio= Price/ EPS (earning per share of a company) *
* EPS= (Net Profit / No. of outstanding equity shares)
Ideally, it is said that if a stock P/E is < 10, the stock is undervalued or fair valued but that’s not always the case. We cannot judge a stock valuation just by looking at its P/E unless it is compared by its industry P/E or any related company which operates in the same sector.
A P/E of a stock conveys a lot more than that. We always heard “that market discounts everything”. Have you ever given a thought about it? Or what does it mean?
Let’s make it simple and understand. We know that we invest today for tomorrow’s return. We invest today so that we could have a great corpus for tomorrow’s retirement. It's just an example, everyone has their objective or goal. But what we have in common is that we all invest today for tomorrow’s return.
Hence, we calculate or estimate future cash flows or earnings of a company and discount it to present value. Hence, we say “Market discounts everything” or “Markets works on discounting mechanism”.
Now, coming back to P/E
P/E ratio is two types:
a) Trailing P/E or Historic P/E
b) Forward P/E
Trailing P/E shows past year P/E multiples whereas forward P/E multiples are calculated based on the company’s forward earnings estimates.
When we look at a stock P/E ratio, there are four circumstances we can think of;
If P/E multiples look high: Either the company’s earning potential looks good thus market rewarded it with such a high p/e ratio or the company is overvalued.
If P/E multiples are low: Either the company’s earnings growth is not good or the market hasn’t yet identified the stock and it is undervalued. There is a great opportunity if invested in these kinds of stocks.
There are far many reasons why the market rewards a company with a low P/E ratio like an issue in management (like public sector enterprises), the issue with economic social and governance compliances (ESG) like ITC, and many more.
How we ourselves look into P/E multiples of a stock
Well, we look into the future growth potential of a company and compare it with its industry P/E ratio. We use the economic Industry and company (EIC) model approach to analyze whether that sector in which we are investing has good growth potential? If yes.
We further, compare the current P/E with its trailing P/E.
Have there any variances? Yes, has the company improved its business model to earn that P/E ? or it's just the market sentiment of demand and supply that has resulted in higher P/E.
After all these analyses we take the avg. P/E of last 3 years and last 5 years and then we take the result and avg. it with forwarding P/E multiples.
Reasons for taking avg. P/E of forward and Past years: It’s because to safeguard ourselves from any wrong assumption that may be taken while calculating forward P/E multiples.
This is just for those who are very new to the market and has no such knowledge of estimating future earnings estimates:
If you want to find the right price buy a stock:
Step 1: Calculate the average P/E of a company for (YTM + 3 years + 5 years).
Step 2: Multiply it with current EPS. (This is given in a P&L of a company).
Result: P/E x EPS, you will get the price of a stock.
Look at the current price and make your decision accordingly.
Important points to keep in mind:
1. Use this method with only a blue-chip company or company with very good fundamentals.
2. Also remember to look past trends in price.
For example Reliance Industries:
YTM P/E: 32.70
Past 3 years P/E: 23.10
Past 5 years P/E: 20.20
Average P/E: 25.30*
so, according to this method, a good price to buy RIL is 1964 rs.
Now, you can use your own judgment whether to wait for the above price or buy at the current price. If you are looking to buy now so that there is no loss of opportunity. How much to invest now? So, if the price falls you have enough to average down your price.
All these points are to be taken care of before buying.
Note: Since no future estimates are calculated there may be chances of buying a stock at a high valuation, the past year p/e doesn’t reflect the stock's true value. So, use this method very cautiously.
Good luck! I hope this blog has helped your way...
Until next time,
The Humane Opportunist.
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