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Dummies guide to Price/Earning ratio

By Sanjay Matai
Last updated on: June 17, 2006 13:44 IST
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Every product or service has a value. A host of factors determine this value, which includes amongst others input costs, fixed costs, taxation, cost of capital, demand-supply scenario, etc.

In many cases these factors are readily determinable and accordingly it becomes easier to determine the fair value of the said product/service.

But in some cases like 'art', determining the fair value is difficult as the factors affecting its price are largely qualitative. 'Equity shares' is another such product where fair valuation is difficult.

Equity shares is seeing increasing acceptance amongst the investor class due to its ability to deliver superior post-tax post-inflation returns, good economic growth, improved regulatory framework, and efficient & transparent mutual funds.

In the last couple of years the Sensex has seen exponential growth.

Hence, it is important to understand how various factors affect the price of a stock, which would then enable us to take a view as to whether at current prices the particular stock is overvalued or undervalued.

Valuation of a stock is difficult as its price may fluctuate differently to short-term factors and long-term factors. Secondly, these factors and their effect on the share prices are not easily computable, making the task of valuation more difficult.

The short-term outlook

Liquidity, demand-supply scenario, political uncertainties, budget, corporate announcements etc are some of the factors, which affect the price of a stock in the short-term.

Suppose there is good news flow for the steel industry. Then practically all the steel stock prices will move up even though some of these companies may not be performing too well.

Therefore, buying and selling in the short-term is more of a trading call than an investment call. It is suited more for a person who can invest his time daily to the stock market.

The long-term outlook

The real benefit of investing in equity markets accrues through long-term investing.

Hence it is more pertinent to understand the stock valuation from a long-term perspective.

In the long run, the price of a stock is the reflection of the operational performance of the company. The expected growth and future profits will determine the price. And because we have to take a view on the future prospects of the company, the industry and the economy in general, assessment of the 'right price' becomes difficult, subjective and prone to large volatility depending on how the future unfolds.

The Price/Earning ratio or the PE ratio is the term commonly used to assess the fairness of the stock price.

PE ratio is defined as the ratio of market price to earning per share (EPS).

PE ratio = Market price of the share
            Earning per share (EPS)
EPS in turn = Profit After Tax (PAT)
                Number of shares in the share capital

The common sense would dictate that lower P/E ratio means that the price is undervalued and higher P/E ratio means that the price is overvalued. Unfortunately, life is not so simple. If it were so, you would not be reading this article. You would be sitting on the stock market and minting money by buying low P/E ratio stocks and selling high P/E ratio stocks.

In absolute terms there is no 'right' PE. One cannot say that PE of a stock of say 10 or 15 is good or bad.

One can only make sense of a P/E number of a particular stock by

  • comparing it with P/E of other companies in the same line of business
  • comparing it with the benchmark indices say Sensex P/E or Mid-cap P/E
  • assessing the growth potential of the industry
  • assessing the growth potential of the particular company

Let's look at a couple of cases - Banking & IT - to get a better appreciation of the P/E number. Banking as an industry enjoys an average P/E of around 8-10, vis-à-vis IT, which enjoys PE exceeding 25-30. The reason is simple - growth.

In a normal scenario the profits of a bank are the spread it earns between the interest rates on deposits and lending. And this usually varies between 2-4 per cent.

If the interest rates on deposit go up, the lending rates will also go up and vice versa. Therefore, the profit potential of a bank is limited. And hence the P/E ratio for banks is usually below 10. The only option for a bank to grow is by increasing the asset size.

Banks like HDFC and ICICI are rapidly increasing their asset base every year vis-à-vis the nationalised banks. Hence, they enjoy much higher P/Es of 20-25.

On the contrary most IT companies are growing at 30-40 per cent p.a. Therefore, in anticipation or likelihood of such high growth rates, the P/E ratios of 25-30 are not unreasonable even for average IT companies. The larger and better companies may even enjoy P/E in excess of 30-35.

Therefore, one should keep in mind that:

  • There no concept of an absolute right PE
  • It is quite normal to invest in a high growth industry like IT with P/E of say 20, but not so for a low growth industry like bank
  • A low P/E vis-à-vis the industry average (e.g. Bank A is quoting at 3 PE as compared to the average of 8 PE for the banks) does not necessarily mean it is cheap. The PE may be low because the bank is having some problems and hence may not be expected to do well in the future.
The P/E number requires careful analysis. Only then can one assess the over or under-valuation of a stock and decide on the investment worthiness of the stock.

The author is executive director, Infra Solutions (India) Pvt. Ltd. He can be reached at

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