PRICE EARNING (P/E) RATIO: HOW USEFUL IT IS?
KNOWING ABOUT P/E RATIO
INTRODUCTION TO PRICE EARNINGS RATIO (P/E):
Almost all the investors know Price Earning Ratio (P/E). It is the most readily available and understandable stock market tool. By historical P/E an investor can gain a primary knowledge about the stock.
Price Earnings Ratio (P/E) is a price multiple. It is the ratio of current market price of a specific stock divided by the basic earnings per share (EPS) of that stock.
Price Earnings Ratio = 𝐌𝐚𝐫𝐤𝐞𝐭 𝐏𝐫𝐢𝐜𝐞 𝐨𝐟 𝐒𝐭𝐨𝐜𝐤 / 𝐁𝐚𝐬𝐢𝐜 𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐩𝐞𝐫 𝐒𝐡𝐚𝐫𝐞 (𝐄𝐏𝐒)
INDICATION OF P/E RATIO:
1. How much money the investors in the market are willing to pay per taka earnings per share of a particular stock.
2. Level of demand of a particular stock represented by per share price investors are ready to pay.
Interpretation of P/E:
- When EPS is negative P/E becomes negative. Negative earnings per share results meaningless P/E.
- In general, high P/E represents high market price compared to earnings per share. A low P/E does not necessarily mean a stock is cheap, just as a high P/E doesn’t mean a stock is expensive.
- What a P/E ratio can do is compare the P/E of one company to another in the same industry, to the market in general, or to the company’s own historical P/E ratios. As with all ratios, it’s important to look at the P/E over time in order to determine the trend of a company’s stock value.
Types of P/E:
P/E can be of many types depending on the earnings used its calculation. P/E can be based on adjustment of basic EPS for different income and expense components: Adjusted P/E and Non Adjusted P/E. Some other P/Es are
Cautions while using P/E:
- P/E is just a comparison between market price and EPS. P/E alone is not a proper stock price indicator. Some other analysis tools must be used in association of P/E. P/E does not indicate NAV of stocks.
- For momentum investors, increase/decrease in P/E depends on major eight reasons as mentioned in the second page of the report. So, it’s difficult to make investment decision based on only P/E without considering the factors given.
- The value investor may decide to invest based on analysis not just of financial ratios but of management competence. The investor could wait and see if the share prices go down further owing to market sentiment about the companies or any industry. The stocks could then be cheap enough for the value investor to acquire with a sufficient margin of safety despite doubts.
- Market fears about the economic situation may also cause all share prices to fall although the fundamentals of the companies have not changed.
Analyst View: The graph shows that there exists a three year cyclical movement of the market P/E from 2003 to 2011. But from 2012 the length of the trend increased & it’s showing a positive trend for the upcoming year 2015. Hence, the ongoing cycle may be closed in late 2016 with adverse downturn.
OVERALL YEAR TO YEAR MARKET P/E
Below charts reflects the Market P/E from 2003 to 2014
Analyst View: Monthly fluctuation of the market P/E has been increased in the year 2008 and 2010. After crash, monthly fluctuation slowing down in the market.
MONTH EFFECT IN THE MARKET P/E
The transparency of year to year Market P/E variation from the January to December from year 2003 to 2014
Analyst View: As the Interest Rate indicates average Deposit Rate of a country, it’s important to take into account while investment decision. If we trust on the Market P/E, it may misrepresent the overall economy as there is a negative relationship between the Interest Rate & Market P/E. Moreover, market follows the general theorem, i.e. investment flow between bank and stock market is negatively correlated.