In today’s burgeoning stock markets, the role of financial ratios is quite paramount as they guide a trade or investor towards investment decision-making. At a time when stock markets are highly unpredictable, traders and investors rely on these financial ratios to find out the historical and future trajectory of stocks in terms of overall growth, market capitalization, popularity, and others. Some commonly used ratios are Profit-to-Earnings (P/E) ratio, Debt-to-Equity (D/E) ratio, Profit-to-Book (P/B) Ratio, etc.
Along with looking at the lowest brokerage charges in India, it is also necessary to consider various financial ratios to understand the stock market and take decisions accordingly.
Whether you’re an intraday trader or long-term investor, it is necessary to make smart use of these ratios to choose the right stock. Among them, the most powerful and widely used ratio is P/E Ratio. It is generally believed that a stock is considered good if it has a high P/E ratio. Let’s find out more about this ratio and things one should keep in mind while investing in stocks with high P/E ratio.
What is the P/E ratio?
This ratio is the ratio of a company’s stock to its earnings per share (EPS).
P/E Ratio=Share price/Earnings per share (EPS)
Earnings per Share or EPS refers to the ratio of the total earnings of a firm to the number of outstanding shares. Numerically,
EPS=Overall earnings of the company/Total number of outstanding shares
Let’s understand this example.
A company has 10 lakh outstanding shares with the market price per share is Rs. 100. Moreover, in the present financial year, the company has a total earning of Rs. 50 lakh.
So, let’s first measure the earnings per share.
EPS = 50,00,000/10,10,000 = 5
Now, let’s find out the P/E ratio. P/E Ratio = 100/5 = 20
It simply means that the investors are paying Rs. 20 to get A Rs. 1 share in the company’s earnings. This happens if investors are confident that the company would accrue more profits in the future. Hence, the mandate for the stocks of the company goes up, and its price increases too, enabling them to earn capital appreciation along with fixed income in the form of dividends. Hence, the P/E ratio is an excellent way to determine the way the market is observing a particular stock.
What do you mean by a high P/E ratio?
A higher P/E ratio reflects that investors are ready to pay a higher share price as of today due to the high growth expectations of the stock in the future. According to the best stock broker in India, The high ratio indicates that investors expect higher growth from the company as compared to the overall market. A high P/E does not essentially mean a stock is overvalued.
However, P/E ratios are not the only deciding measures. Every industry or sector can have various P/E ratios. Hence, there is no average measure of a high P/E ratio. It is always measured against the company’s competitors. For example, if you look at the FMCG sector, a majority of firms have a P/E ratio between 25 and 50. If a company falls under the FMCG sector, then its P/E ratio is extremely low. However, if the same company belongs to the Textile Sector where the average P/E is between 5 and 8, then the P/E ratio of ABC Ltd. is high.
Factors that encourage high P/E ratio
Regular growth in earnings – Investors prefer to invest in stocks of firms that showcase consistent performance and have reliable and lasting growth paths and earnings. Thus, companies that offer a steady growth in earnings are favored and investors never hesitate to pay more to obtain a share in their earnings.
Profitability – While growth is impressive, not all firms successfully transform the growth into profits. Hence, companies who showcase efficiency in this regard are favored and have a higher P/E ratio.
ROE – This is another financial ratio that many investors take into account before arriving at a decision. This shows them if a company can professionally convert shareholder equity into profits. In general, companies with higher ROE ratios are liked by investors particularly if they have low debts. The P/E ratio for such firms is found to be higher too.
External factors – Macroeconomic conditions affect the entire stock market. Therefore, various policy choices or macroeconomic scenarios can cause the price of a stock to go up causing an increase in its P/E ratio.
Things to keep in mind while investing in stock with a high P/E Ratio
Though a high P/E ratio means that it is good to invest in that stock, this necessarily doesn’t apply in all cases. Before you move ahead with investment in high P/E stocks, take a look at the following pointers.
As P/E is just a ratio, a higher numerator or lower denominator can lead to a higher P/E. Therefore, The Numerator (Share Price) – If the market price of a stock goes up due to reasons other than the company’s performance, then the P/E ratio tends to be higher. However, it might not resound with the company’s overall recital and the demand may not last long. The Denominator (EPS) – EPS refers to the ratio of the earnings of a business to its exemplary shares. If the company releases more shares, then its EPS tends to slump. This tends to increase the P/E ratio of the company. In addition, if the company has lower earnings in a financial year, then its EPS will be low resulting in a higher P/E ratio. In most cases, investors check the popularity and stock demand by comparing a company’s P/E ratio with its peers. Therefore, it is necessary to keep all the factors before moving ahead.
The stock market tends to be extremely volatile. Since the P/E ratio rests on the market price of the share, when other factors make the market risky, the stock price follows the same pattern. This makes it harder to get a consistent P/E ratio. Hence, avoid using the P/E ratio to examine the demand for a stock during extremely volatile market scenarios.
A high P/E ratio can be an excellent sign of a company having amazing growth prospects. However, it is not sufficient to consider the P/E ratio only. Make sure that you look at the financials and basics of the company and its competitors to ascertain its growth prospects. This can help you make a sounder decision.
While there are lots of tools and financial ratios are available that can help check a company’s forte and the succeeding advantages of investing in its shares, it is necessary to keep in mind that the market price of a share is not ruled only by the company’s performance. Other determiners like the political, social, economic, etc. have their role on the stock price too. Thus, before investing, it is imperative to comprehend the business of a company, its prevailing competition, and its placement in the market. Always understand that it is not good to invest in a business that you can’t understand. Consider all the aspects of the company before arriving at a decision.
Though investing in companies with a high P/E ratio is a good decision, it is also necessary to take all underlying factors into consideration for better outcomes.
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FAQs
What is a PE ratio and what are the different types of PE ratios?
A PE ratio or price-to-earnings multiple for a company is one of the most widely used methods used to select a company while investing. It is projected by dividing the existing market price of a company’s share by the company’s 12-month earnings per share. When the price of the share is divided by the last 12-month earnings per share (EPS), it is called trailing PE. On the other side, when the price of the share is divided by the estimated next 12-month earnings per share (EPS), it is known as the forward PE ratio.
What are the factors that influence the PE ratio?
Some of the major factors are earnings steadiness, interest rates, ROIC, and Dividends, etc.