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All About PE Ratio

What do we infer from a higher PE ratio and a lower PE ratio and which one is better?
-J. Banerjee

What do we infer from a higher PE ratio and a lower PE ratio and which one is better?
-J. Banerjee

It is the ratio of the share price of a company to its earnings per share (EPS). EPS is the profit that a company makes on a per share basis. Because of this relation with a company's profits this ratio is also called the earning multiple. For a company, a PE ratio tells you how much investors are willing to pay for one rupee of its earnings (profits).

Some shares have higher PE ratio and some lower. Higher PE ratio signifies that investor expectation from these shares is higher. This is because the growth in share price is expected to follow earnings growth. So, if investors are willing to pay more for a share, it is because they are expecting faster growth of profits. These stocks are often referred to as growth stocks.

At the other end are companies which have a low earnings multiple. Here, investors are not expecting much growth, and these stocks are called value stocks. The situation could change as a company that has been growing slowly can gather pace and a fast-mover can slow down. Growth and value are thus not static concepts.

As regards mutual funds, first of all, an equity fund is a collection of shares. Therefore, a fund's PE is the average of the PEs of all stocks, in proportion to their presence in the portfolio. Because fund portfolios change, the PE will also change and this will not reflect the growth prospects of the underlying assets. A fund's PE is the weighted average PE of its stocks. Cash has no role to play. Thus, caution has to be exercised and the cash component has also to be factored in while looking at PEs. Similarly loss-making companies are assigned a zero value. For these reasons, a fund's PE is not as relevant as that of a share. Nonetheless a fund's PE can be used for comparing funds in its category, or in comparing categories. If you are investing in a value fund, then expect the fund to have a PE lower than that of growth funds. Similarly, mid-cap funds will generally have lower PEs than large-cap funds. Hence, a fund's PE ratio can tell us whether the fund has more growth stocks or value stocks compared to another fund. But remember, just as growth and value are not static concepts, the PE of a fund also will change.

A PE ratio is not good or bad in itself. It has to be seen vis-a-vis various factors. For example, as we have mentioned earlier, a higher PE indicates expectations of faster growth of profits. Therefore, it would seem that such a stock is a good bet. But actually, the truth might be that the expectations are irrationally high and the stock is not worth the price it is commanding at the moment. Such a stock can become the recipe for disaster. On the other hand, while picking a low PE stock, one has to ensure that it is a fundamentally good company and the PE is low either because the stock has not yet caught the attention of the markets at large or is out of favour presently , or it happens to be a low growth but very stable company and you are banking upon the higher and consistent dividend income from the stock.



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