How PE valuation can help you time your stock investment

Price is what you pay, value is what you get—Warren Buffett

If you are looking for a metric that can offer you ready information about the price and value of a business then you must read about Price-to-Earnings (P/E) ratio.

P/E ratio is one of the most famous valuation ratios that various market participants frequently refer to. Let’s see how it is calculated, what the benefits of P/E valuation are, and the importance of P/E ratios when evaluating stocks.

You can use any of these formulae to arrive at a stock's P/E ratio

P/E = Market price per share/EPS

(Note: Where EPS or Earnings Per Share = Net income/ total number of outstanding shares)

Or you can simply use market cap and net income numbers to find out P/E

P/E = Market Capitalisation / Net Income for the past 12 months*

(* Note: You can also use projected earnings instead of Net Income)

The P/E ratio of a company or a sector or of an index can be calculated based on:

• Trailing Twelve Month (TTM) earnings
• The last reported full-year earnings
• Forecasted earnings

But what exactly is P/E ratio?

If you carefully observe the values considered for calculation, P/E denotes how much a stock buyer is paying with respect to the company’s current earnings. In other words, if the answer of your P/E  calculation is 15, it indicates that an investor is paying Rs 15 for every Rupee that the company earns. Put differently, the current earnings would take 15 years to match the initial investment amount of an investor.

The P/E ratio of a company can rise or fall due to changes in the Market Cap. (or stock price) and/or changes in its Net Income (or Earnings per Share).

The P/E ratio of a company can be compared with that of:

• Its peers
• A relevant sectoral index
• An index representing the broader markets

The current P/E ratio of a company may also be compared with the company’s own historical P/E values.

How to interpret P/E ratios?

It’s quite tempting to infer that low P/E stocks are attractively valued and high P/E stocks are overvalued. However, if these inferences are based on an absolute number then that may not be an intelligent way to use P/E ratio.

Not all companies witness the same growth trends. Companies that are expected to grow rapidly enjoy higher P/E multiples and vice-versa.

Using P/E ratio intelligently

• P/E ratios of cyclical companies such as those operating in engineering, infrastructure and metals amongst others can witness wild swings.
• While evaluating cyclical stocks on P/E valuations, you should consider up-cycle and down-cycle valuations to decide where the company stands today.
• Companies operating in a fragmented industry such as retailing may enjoy incredible P/E valuations since they likely benefit from the formalisation of businesses.
• It is usually found that long period averages serve as a good benchmark to judge whether a stock is undervalued or overvalued.
• Interest rate environment in an economy can vastly affect P/E valuations. Under low to ultra-low interest rate environment, companies generating higher free cash flows can attract investors, thereby sending the P/E valuations upwards.

Can P/E valuations help you time the market?

While it is important to remember that nothing can help you time the market successfully forever, a stock depicting reasonable growth and trading around or below its long period averages may offer you good entry points.

Precautions to take while using P/E valuations

P/E valuation is one of the quickest methods to check the price-earnings equation. However, in isolation it won’t help you take rational decisions. You should analyse a range of other factors that affect the company’s growth prospects.