Generally in stock markets we are interested in stocks that are not overly priced. Because it may not give good returns on the capital employed(not always). But, How do we identify whether a stock is overvalued or undervalued. We can identify such stocks with the help of P/E ratio. P/E ratio is the famous metric to estimate the valuation of the stock.
P/E ratio is calculated by dividing the current price of a share by earnings per share(EPS).
Higher P/E value indicates that the price of the stock is relatively high to its earnings. We can mark the stock as overvalued stock.Lower P/E value indicates that the price of the stock is relatively low to its earnings, and it will be an undervalued stock.
Formula for P/E Ratio:
P/E Ratio = Current Market Price of a Share / Earnings per Share
Here the Earnings per Share may be calculated for different time periods. But, most of times EPS is calculated for one year.
Example for P/E Ratio:
A company named "ABC" stock trading at 200rs, and the EPS of the company is 5rs. Then P/E ratio will be 40. Another company named "XYZ" stock trading at 200rs, and the EPS of the company is 10rs. Then P/E ratio will be 20.
P/E Ratio in detail:
Assume that both ABC and XYZ are large cap IT companies, and IT industry P/E is 30. Now, we will try to understand P/E ratio in detail. In company ABC case we derived P/E as 40. It means that investors are ready to invest 40 rs for 1rs of its earnings. In XYZ case investors are willing to invest 20rs for 1rs of XYZ company's earnings. If you observe for the same current market price investors paying 20rs more for ABC shares relatively to XYZ shares, paying 10rs more to the IT industry P/E ratio. Which is overvalued. On the other hand XYZ P/E is lower than the IT industry P/E, which is undervalued.
How do you use P/E ratio for investments:
Generally, investors in the stock markets are of two types. Value investors and Growth investors. Growth investors ignore the P/E ratio if they believe the company's future growth potential. Value investors look for the companies with low P/E ratio and with strong fundamentals with a belief that it can achieve good growth in the future, even if it does not grow due to temporary reasons. If the company really performs well value investor will get good returns on the capital employed.
To read:
What is Face Value, Book Value and Market Value of a share
What is EPS(Earnings per Share )
What is Market Capitalization? and its importance in stock market investments
Disclaimer : All the information provided in this article is purely for education purpose only, and it is not an investment advise. Please consult your personal financial adviser before taking any investment decisions.