VR Logo

Smart Investing: PEek Through

PE denotes the amount that you are willing to pay for one rupee worth of the company's earnings

All of us have at some point have made purchases that in retrospect seem over priced. On the flipside, there is no denying the absolute joy of finding a real bargain!

But how do you assess such bargains in case of stocks? How do you tell whether the current price quotations are rational? Is the price in line with the earning potential of the company? In case you follow a top-down approach to investing, is there something better priced within that sector? Solutions to these queries to some extent can be found in the price-earning ratio (PE).

One of the most common tools for stock picking, PE is the prevailing stock price of a scrip divided by the earning per share (EPS). Breaking it down mathematically, PE denotes the amount that you are willing to pay for one rupee worth of the company's earnings.

Let's say that you are presented with two companies, A and B, functioning in the same industry. The PE of A is 24 and that of B is 16. The logical question is why would an investor pay Rs 24 for a rupee worth of earnings made by A as against a much cheaper Rs 16? The answer is dreadfully simple: Because investors perceive A to have a better growth potential than B.

The reason why investors perceive a low PE as a bargain buy is because a low PE may mean that the stock price has not risen to reflect the earnings potential of the company.

PE can at the same time give a clear warning of a highly over-priced stock, for instance the PE of BF Utilities stood at 2,934.8 times (as on November 24, 2006), when the price of the share was Rs 3,233. Like all other financial ratios interpretation of PE is contingent on peer group comparisons. This is because a PE of 20 times may be considered too high in some industries while it may be considered cheap in others.

At the same time, apart from demand and supply dynamics, the future earnings of a company are often built into its price. You must have noticed how the announcements of a large order, lead to a spurt in the price of the stock. This would then essentially increase the PE.

Sadly, the PE is not a sure short answer to all your stock picking woes. A low PE would not necessarily mean that you found a good bargain. For the lower PE may be the result of graver issues. At the end of the day there is really no substitute to a thorough information search before deploying your money and PE is just one of the variables that must be included in your consideration set.

Information on PE based on reported EPS is easy to come by, as it is reported along with the stock price of the company in most dailies. You will come across many reports stating estimated PE. This is calculated on the basis of a forecasted EPS, based on the past growth trends of the company and is subject to assumptions.