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Saturday, April 24, 2010

P/E Ratio - To determine relative value of stocks

Value investors have long considered the price to earnings ratio (P/E ratio for short) a useful metric for evaluating the relative value of a company's stock price. Made popular by the late Benjamin Graham, "Father of Value Investing". Graham preached the virtues of this financial ratio as one of the quickest and easiest ways to determine if a stock is trading on an investment or speculative basis.

Price to Earnings Ratio description

The P/E looks at the relationship between the stock price and the company’s earnings. The P/E is the most popular metric of stock analysis, although it is far from the only one you should consider.

You calculate the P/E by taking the share price and dividing it by the company’s EPS.

P/E = Stock Price / EPS

If a company is reporting basic or diluted earnings per share of Rs. 20 and the stock is selling for Rs. 200 per share, the P/E ratio is 10 (Rs 200 per share divided by Rs. 20 earnings per share = 10 P/E.)

Most stock-quote systems such as Yahoo! Finance, Rediff Money will automatically figure the price to earnings ratio if you ask for a detailed quote on any company.

Once you have the magic number, it's time you begin to use its power. It can help you differentiate between a less-than-perfect stock that is selling at a high price because it is the latest hot-pick on Dalal street, and a great company which may have fallen out of favour and is selling for a fraction of what it is truly worth.

First, you have to understand that different industries have different P/E ranges that are considered "normal". For example, technology companies may sell at an average P/E of 20, while textile manufacturers may only trade at an average P/E of 7. There are the exceptions, but for the most part, these differences between sectors are perfectly acceptable. They arise out of different expectations for different businesses; technology stocks usually sell higher because they have a much higher growth rate and earn high returns on equity, while a textile mill, subject to dismal margins and low growth prospects, will trade at a much smaller multiple.

One way to know when a sector is over priced is when the average P/E ratio of all of the companies in the industry is far above the historical average. (A sector is a group of companies in a particular line of business; e.g., pharmaceuticals, advertising, utilities, etc.)

Price to Earning Ratio to compare companies in the same industry

In addition to determine which industries and sectors are over / under priced, you can use the P/E ratio to compare the prices of companies in the same sector against each other. For example, if company ABC and XYZ are both selling for Rs 100 a share, one is not more expensive than the other. Wrong!

Company ABC may have reported earnings of Rs 20 per share, while company XYZ has reported earnings of Rs 40 per share. Each is selling on the stock market for Rs 100. What does this mean? Company ABC has a price to earnings ratio of 5, while Company XYZ has a P/E ratio of 2 1/2. This means that company XYZ is much cheaper on a relative basis. For every share purchased, the investor is getting Rs 40 of earnings as opposed to Rs 20 in earnings from ABC. All else being equal, an intelligent investor should opt to purchase shares of XYZ; for the exact same price (Rs 100), he is getting twice the earning power.

Price to Earning Ratio limitations

Remember, though, just because a stock is cheap doesn't mean you should buy it. If a company's stock price has fallen, do your research and discover the reasons. Is management honest? Are they losing key customers? Look at insider buying. Is the Board of Directors buying stock in the company? If the weakness is across the entire sector or just because of temporary bad news that doesn't change the bottom line, then consider buying.