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Understanding the P/E ratio

The P/E ratio is the most common valuation tool. But it's not flawless. Here is all you must know about it.

Understanding the P/E ratio

"Price is what you pay, but value is what you get."
Warren Buffett

If you think that you can make money by simply investing in a growth stock, then think again. Even if you buy a fabulous business that consistently grows its profits, you are unlikely to earn returns on your investment if you pay a fortune on acquiring the shares. This is precisely where the importance of buying a business at a sensible price comes into play. And to calculate a sensible price, you need to use valuation metrics.

Price-to-earnings ratio (P/E) is one of the most widely used valuation methods. This ratio shows how expensive a company's share price is as compared to its earnings. In other words, it is the amount of money you would pay for every rupee of profits earned by the company.

We can illustrate it with an example. For example, if a company's share price is Rs 1,500, with its earnings per share being Rs 100, then it can be said to be trading at a P/E ratio of 15. The numerator is either the price per share or the market capitalisation of the entire company and the denominator is either the earnings per share or the total earnings of the company. (Kindly note that by earnings, we are referring to profits or bottom line instead of sales or top line). Besides, estimated earnings of the next year can also be used as an input.

The P/E ratio gives a very quick and intuitive value that can be used to compare stocks across all sectors, market capitalisations and time periods. It is easy to compute and widely available on most financial websites.

Even though the numerator, which is the share price, is easily understandable, there are different variations in the denominator i.e earnings. Since earnings is an accounting measure, it can be manipulated by the company's management in various ways.

Another problem is that the P/E ratio does not differentiate between one-time earnings (such as the sale of a factory) and regular earnings (operational profit which is likely to recur in the future). Also, this ratio varies in companies which are operating in cyclical industries. Since the earnings of these companies follow a cycle, the P/E ratio looks optically lower during up-market phases of the cycle and seemingly high during down-market phases of the cycle.

Last but not least, this ratio is not applicable when a company does not make profits. Since a negative P/E is meaningless (no conclusion can be drawn from the magnitude of the negative P/E), this metric cannot be used to value startups (which generally make losses for quite some time before they start making profits) or mature companies which made losses due to one-time events such as the write-down of a goodwill or inventory losses.