Recent years have seen tremendous growth in the stock market. Virtually everyone is trying to jump into stocks to make a quick buck. Generally stocks are being picked based on rumours or some hot tip. It is all right to pick stocks in this fashion provided you trust the source. If you don't then a preliminary analysis with P/E ratio will tell you how the company is faring and whether or not you should buy the stock. P/E ratio compares a company's stock price to its earnings.
i.e. P/E = (Stock Price) / (Earnings per Share)
Earnings per Share is generally available with the company's financial information. Simply stating EPS is calculated by dividing the earnings (net profit) by the total number of equity shares. Thus, if XYZ has 2 crore shares and has earned Rs 4 crore in the past 12 months, it has an EPS of Rs 2.
Now to calculate earnings per share you can use last years earnings or next years estimated earnings. Using these you get 2 ratios backward P/E ratio (using last years earnings) forward P/E ratio (using estimated earnings). People generally prefer forward P/E ratio.
The P/E ratio takes the stock price and divides it by the last years earnings. If XYZ is currently trading at Rs. 20 a share with Rs. 4 of earnings per share (EPS), it would have a P/E of 5. Big increase in earnings is an important factor for share value appreciation. When a stock's P-E ratio is high, the majority of investors consider it as pricey or overvalued. Stocks with low P-E's are typically considered a good value. However, studies done and past market experience have proved that the higher the P/E, the better the stock.
A Company that currently earns Re 1 per share and expects its earnings to grow at 20% p.a will sell at some multiple of its future earnings. Assuming that earnings will be Rs 2.50 (i.e Re 1 compounded at 20% p.a for 5 years). Also assume that the normal P/E ratio is 15. Then the stock selling at a normal P/E ratio of 15 times of the expected earnings of Rs 2.50 could sell for Rs 37.50 (i.e rs 2.5*15) or 37.5 times of this years earnings.
Thus if a company expects its earnings to grow by 20% per year in the future, investors will be willing to pay now for those shares an amount based on those future earnings.
In this buying frenzy, the investors would bid the price up until a share sells at a very high P/E ratio relative to its present earnings. First, one can obtain some idea of a reasonable price to pay for the stock by comparing its present P/E to its past levels of P/E ratio. One can learn what is a high and what is a low P/E for the individual company. One can compare the P/E ratio of the company with that of the market giving a relative measure. One can also use the average P/E ratio over time to help judge the reasonableness of the present levels of prices. All this suggests that as an investor one has to attempt to purchase a stock close to what is judged as a reasonable P/E ratio based on the comparisons made. One must also realize that we must pay a higher price for a quality company with quality management and attractive earnings potential.
The above point will be discussed in detail when we discuss PEG ratio.
Another important factor to keep in mind is that P/E by itself would only tell you half the story. You need to compare the P/E of a stock with its competitors to get a fair idea how that sector is being rated.