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PE Ratio



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Hello and welcome to this session on PE.

In yesterdays class, we framed some rules:

Rule #6: Prefer consistently profit making companies. Look for companies that make profits (in particular operating profit, profit before tax and net profit)

Rule #9: Look for companies that are constantly growing in terms of Sales growth.

Rule #10: Prefer companies which are debt free or having no loans.

Recap on Financial Ratios

We started our discussion on Financial ratios / numbers

We know we can get all this data by observing in screener or in balance sheets of the company.

There are four types of financials ratios:

1. Financial Ratios

2. Profitability Ratios

3. Leverage Ratios

4. Operating ratios

Financial Ratios discusses about the financial aspects of the company

Profitability Ratios tells us about profit related aspects such as how and where the profit has come, from which type (operations, investments etc)

Leverage Ratios tells us how stretched / flexible the company is, how much does share holders get if company is closed or shut off etc.

Operating ratios focusses on the operational aspects (core business activity) of the company, revenues etc.

There are several ratios that come under each of the fourt types

We said, our focus will be on three such numbers:

1. Stock PE and Industry PE

2. Book Value

3. Operating Profit Margin

P/E Ratio

Lets start with P/E Ratio

The *P/E Ratio* is the first and foremost type of ratio one should learn.

P = Price

E = Earnings

So P/E Ratio is Price Earnings Ratio

  • Important*

Do not get confused thinking E = Equity.

PE = Price Earnings Ratio

Let see the *formula for P/E*

P = Current market price of the share = Market Value Per Share

Earnings = Earnings Per Share (EPS)

So, P/E = CMP of the share / EPS

or

P/E = Market Value Per Share / EPS

Earnings per share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock.

How to get EPS of a share?

EPS number will be announced by the company during quarterly results time.

If you are interested, there is a formula for that as well:

EPS = Profit generated / Outstanding shares.

outstanding shares = all types of shares of the company as per company books

i.e shares held by all shareholders including institutional holding, retail holding etc.

For example,

Assume a company issued 1000 outstanding shares.

Assume that it generated a profit of Rs. 2,50,000

So, its EPS = Rs. 2,50,000 / 1000 = Rs. 250

Assume the shares CMP is Rs 750

So PE = 750 / 250 = 3 times

Do not worry about the calculations.

The P/E number will be shown on all stock websites.

What does the PE tell us?

In the above case,

for every unit of profit generated by the company,

the market participants are willing to pay Rs.3 to acquire the share.

This is an important interpretation.

Simply said, it tells us the demand for the shares of the company.

Now, let us assume the CMP went up to Rs. 850

Will change in CMP make a change in EPS?

No. There will be no change in EPS because the EPS formula does not involve CMP.

But, a change in CMP will change the PE.

So PE = 850 / 250 = 3.4

We can observe that:

When CMP goes up, the PE goes up too.

The stock price of a company increases when the expectations from the company increases.

i.e with an expectation that the company will make increased profits.

Assignment Alert

1. Visit moneycontrol.com

2. Focus on some stocks from Private Banking sector

3. Find out all stocks that are better than the banking sector PE

4. Then compare OPM between the filtered stocks

When dealing with equity share investments, one of the most common question we come across is:

Is the share current market price (CMP) right to invest?

Can we buy at this level?

There are several factors and ways of determining this.

Two important methods are:

1. Computing valuation (which we will study in the lesson CMP-Valuations)

2. PE is a good indicator to determine how expensive or cheap the stock is trading at.

So, if a company PE is over 25, it would generally mean it is expensive.

We should avoid or reduce investing in such stocks.

  • Note*

PE is a good measure for almost all industries except in those whose business soley depends on money.

Hence, PE numbers are not an efficient measure for Banks and NBFC sector (which we will study in Evaluating-Banks-NBFC lesson)

How to use the P/E number?

  • We need to compare the P/E of a share with its sector / industry.*

So, this will be our new rule.

  • Rule #11: Compare Company PE with Industry PE*

I will give you an example.

For instance, take the share of SBI.

SBI comes under which sector / industry?

Banking sector! Indeed!

In particular, it is comes under the sector / industry called Public Sector Banks

In stock markets, Banking sector is studied under two sub-sectors:

1. Public Sector Banks

2. Private Sector Banks

Now let us check the PE of SBI and the Industry PE of Public Sector Banks

I will take the value of P/E of SBI and Industry P/E from MoneyControl website.

http://www.moneycontrol.com/india/stockpricequote/banks-public-sector/statebankindia/SBI

If you have moneycontrol app you can search in that as well.

SBI PE is 23.21

Industry PE is 16.59

Compare SBI PE with Industry PE. What is the inference?

This means SBI has over performed than that of the Industry

The gap is around 6 or 7 points. So it is way above

In our example, we are comparing the company PE with its sector / industry PE.

To determine if the company is performing better or worse to the industry.

Lower PE means the stock is trading cheap.

If other factors also help and suggest that the company is a good one, then we can see SBI stock PE should reach at least the to the level of Industry PE.

Now, we get a question:

If SBI has performed well, does that mean we should not buy it ?

We shd evaluate the reason for the non-performance of the stock and decide.

What is wrong with SBI?

If u feel that:

there is nothing wrong with sbi and

there is nothing material that changed in recent times

yet stock price went up then,

.. there is a possibility of the stock price coming down.

The performance of the stock depends on several factors.

The financial ratios are just an indicators.

Fundamental analysis uses several factors to arrive at a conclusion.

Remember, i am giving SBI as an example here.

It is not a recommendation to buy or sell!

We are not here to give or share tips or suggestions!

What i mean to tell is that, understanding and comparing PE ratios of stock with industry is important

When using Industry PE data, ensure that you obtained the correct industry data.

For example,

For SBI PE, u need to compare with Public Sector Bank PE

For ICICI Bank PE, u need to compare with Private Sector Bank PE

Public Sector PE is not same as Private Sector PE

  • Important*

Industry PE number might be differ from one stock to another from the same sector in moneycontrol. Ignore that difference.

This happens because quarterly results announcements are going on.

So for some stocks, updated industry PE is shown on the website on some company pages

but for other stocks, old numbers are shown.

Another important thing is that the Industry PE numbers would be shown differently on different websites.

For example,

MoneyControl shows Plastics Industry PE as 58.14 while Edelweiss shows it as 28.59

This difference occurs when an stock is incorrectly classified.

For example, in the above, MoneyControl has classified VIP Industries as a plastics company while most other websites have classified it as a Consumer Durables company.

For a list of Valuation PEs of various sectors / industries, please check https://www.edelweiss.in/sector/

  • Question: PE ratios of some companies indicates negative number whereas some other doesn’t even show at all in Money control websites. Why is it so?? Probably earnings are negative?*

PE means Price / Earnings

Price is the market price of the share and cannot be negative.

But Earnings can be negative. Negative earnings = loss making company

EPS values below zero mean that the company is losing money and is the reason why it is possible to have a negative P/E ratio.

Such companies are risky to invest in.

The best source for taking PE data is to take the EPS value from the latest quarterly report of the company and compute PE.

I hope you understood about PE Ratio and how to use it.

Can we move to the next topic?

So if the stock's PE is higher then the Industry's PE, it means correction may be due in stock's price...

@Tiwari: Yes. Overperformance of a single stock compared to the industry could not be for so long. Of course, this need not be a sole indicator.

So if the stock's PE is higher then the Industry's PE, it means correction may be due in stock's price...

@Sunny, Somiyaji: NPA are bad and unrecoverable loans. So they are written off from the books and will effect the capital account of the company. Something commerce related topic.

@Pranesh

So if the stock's PE is higher then the Industry's PE, it means correction may be due in stock's price...

So can u explain banking or financial sector separate

@Pranesh: I dont think we can afford a discussion exclusive for sectors. But i will try to do something like that outside our usual times. I have a lesson scheme prepared and because of delays, the 30-day class now got extended to 45-days. I cannot afford further extension.

Sunny Guwalani

vijay sir oblige kindly...fall in NPA was nt only the soul reason for fall in banking stocks...this is what i wanted to point oit

half baked info not suitable fot trading

Indeed. No single factor solely affects a company and its share price. A combination of them will do. Further, we are not into trading but long term investing.

Question on Annual EPS and Quartely EPS:

ITC in its recent quarter results showed EPS 2.04

Annual march 2016 EPS was 12.23

Does it mean EPS fall down by 10?

Or we shouldn't compare annual result EPS with quarterly?

No. That dosent mean EPS fell down. So far, for this year, it made 2.04.. May be it will make up the remaining 10 or even better for the next few quarters if the company is performing well. Annual EPS cannot be compared to Quarterly EPS.

  • What is Industry PE? Why does different websites give different Industry PE numbers?*

Industry PE is the average of all individual company PEs across all the stocks that belong to the same industry.

So, if we take the Automobile industry, if you average the PE of all the Automobile stocks, we get the Automobile Industry PE.

Now, assume that there are 25 Automobile companies but i used only 24 companies in my computation while other hand, you included all 25, obviously my Industry PE numbers will differ from that of yours.

This is exactly why Industry PE numbers sourced from one website will be different to others.

In the case of Ashok Leyland, my website categorized under Automobile - LCV and HCV which means they brought together all Light Commercial Vehcies (such as Autorickshaws) and Heavy Commerical Vehicles (such as Trucks) into a seperate sub-category. Most other websites would generally stop at Automobile as an industry.

Another classical example is with VIP Industries being classified as Consumer-Durables while some others classify it under Miscellenous category.

So the difference in Industry PE numbers between websites is because of the inclusion or exclusion of companies in their respective lists for computation.

ITC PE 29 and industry PE is 30 Price is fair EPS is increasing since 2012 annually But yoy percentage of increasing EPS is reducing. What should b view?

Yes. This means that the company is not making sufficient profits though the size of the company is growing. This is one sign of maturity of the company in its markets. FMCG stocks generally will be like this only. Slow movers. Profits because of volumes and not by margins. We need the share price to drop substantially, say, sub 220 levels to make it worth the CMP.

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