When you buy stocks, financial experts often ask you to look at the Price Earnings (P/E) ratio of the company. This ratio will tell you whether the stock is undervalued or overvalued. However, before you check the P/E ratio you need to understand what PE is and how to evaluate a stock using this ratio.
What is P/E ratio?
P/E ratio is used to value a company using its share price and earnings. The formula goes like this – Current Market Price (CMP) per share / Earnings Per Share (EPS). EPS is calculated by dividing a company’s net income by the total number of outstanding shares. It is the portion of a company’s profit that is allocated to every individual share of the stock.
So P/E measures the amount an investor would be willing to pay for every rupee of the company’s earnings. So, if the PE ratio of a firm is 15, it means that investors are willing to pay Rs 15 for every rupee that the company earns.
Generally, the EPS for the past year or last four quarters is used to calculate the ratio. This P/E is known as a trailing P/E. One could also take analyst projections of earnings for the coming four quarters or year, to calculate PE. This is known as the forward P/E. P/E is a positive number. Even though analysts say there is a negative PE, it has no meaning and cannot be used for any analysis.
Variation of P/E – PEG
PEG is Price Earnings to Growth ratio. This metric is used to value a company. Only here, unlike P/E, along with the stock prices and the earnings of the firm, the expected growth of the company is also considered. The lower the PEG, the more attractive is the stock in terms of its value. This is precisely the reason why PEG is said to be a better measure than the P/E. The formula goes like this – P/E ratio/growth rate of the company’s earnings for a particular time period. The alternate formula is P/E ratio/Annual Earnings Per Share growth. Usually, if a firm’s PEG is below 1, it is considered a ‘value’ stock. Always use growth estimates for 5 or more years.
How to use P/E and PEG?
Usually, a low P/E for a popular firm is taken to mean that the company is undervalued. However, P/E is an indicative measure. This means that P/E doesn’t have any value unless you compare it with the P/E of similar firms or the market. In India, it is believed that when a company has a P/E below 10, the company is undervalued. However, it is mostly the small caps that have such P/E and it might be risky to invest in them.
When taking P/E for stock investing, it is also important to consider the average P/E of the firm for the last 10 years. Take ITC for instance, the current P/E of this firm stands at 28.7. The average P/E for the last 10 years for ITC has been 26. This means that ITC might be overvalued. Note that P/E shouldn’t be taken as the single measure for investing in the shares of a company. Other factors such as financials of the company, future prospects and market share in the industry have to be considered.
Just like P/E, PEG can also be calculated as trailing or forward. The latter might give a truer picture, as past growth may or may not be sustained in future. When forward PEG is more than 1, it can indicate two things. One is that the market expects growth of the firm to be much higher than what analysts estimate. The second is that the stock could be overvalued due to a great demand for the stock.
If the forward PEG is less than 1, it could be due to two factors. Factor number one being that markets are undervaluing the potential growth of the company. The second factor would be that analysts have set growth below reasonable limits. It is important to analyse both the factors before making a decision to invest in low PEG stocks.
The best part about PEG is that you can compare stocks across industries using this ratio. This is not possible using P/E. For instance, if you have an oil company and a tech company that you want to invest in. You can compare their PEG and choose the one that is undervalued. However, note that PEG doesn’t take into account the dividend income from a stock.
If you are not familiar with stock investing, it is best to invest in mutual funds first to understand equities. Mutual funds are professionally managed and so it saves you the headache of actively managing a portfolio. Read this article for more information –New To Mutual Funds Investing? We Get You Up To Speed.