What is PE Ratio?|Simple Explanation

The basic principle of investing is to buy low and sell high. So, we should buy a company stock when it is undervalued and sell it when it becomes overvalued, but how do we know whether a company is currently undervalued or overvalued? Well, the PE ratio can help. PE ratio means price to earnings ratio.

The price here refers to the current market price of the company per share. You can check the last traded price of any company and that will be the P and the E here refers to the earnings per share. That means how much profit is the company generating per share.

Let’s take an example to understand this better.

Here, we have a company called ABC Corp that generates 10 Lakh rupees of net profit per year and this company is listed on the stock market where its current share price is 100 rupees and there are a total of 2 Lakh shares. Let’s calculate the PE for this company. The P part is very easy and is the share price of the company which is 100 rupees.

Now the E part, that is earnings per share is something that we have to calculate. The earnings per share would be 10 lakhs divided by two lakhs and that is 5 and hence the earnings per share is five. Now calculating the PE ratio is very easy which is Price that is rupees 100 divided by the earnings per share that is 5.

So, we get the PE of 20 and hence the PE ratio of this company is 20. Now a lot of you might be wondering that you have to calculate this thing for every company. The good news is that you don’t need to calculate these numbers and you can easily find that on a lot of websites for free.

For example, in Zerodha you can check out the PE here and on money control, you can check out the PE here. So, PE values are everywhere and you don’t need to do any kind of calculations.

But let’s pause here for a second and ask this very basic question. If ABC Corp is generating only 10 lakh rupees of profit, then why is the market value of the company 2 crores? Shouldn’t it be 10 lakh rupees or something close to that. Well, this is something that you need to understand very clearly.

Imagine 2 engineering graduates, one from a good engineering college and the other one from IIT Mumbai, both of them are at the same knowledge and skill level. Who do you think will get a higher salary during the campus placement?

The IIT guy, right. But, why shouldn’t it be argued that if the knowledge level of both the students is exactly the same, they should get paid exactly the same. Well, it all boils down to the expectations and the confidence that the recruiting firm has in the future ability of these students. Since the 2nd kid is coming from an IIT, the expectations are higher and hence the company is willing to pay him a higher salary. Now 10 years down the line, the reality might turn out to be something different, but at least as of now, the IIT guy is going to take home a higher salary. In the same way some companies command higher PE as compared to others because investors have higher expectations and confidence in their business models, management ability or their competitive edge.

So higher the PE ratio of the company, the higher is the investor’s expectation of the growth of the company.

Typical Value of P/E

So, in reality, what is a typical value of a PE?

Now here’s the most frustrating part for a lot of new investors. They look for a typical PE value above which they would know that the companies are overvalued and below which the companies are undervalued.

In real life though, the problem is that the PE for companies range from as low as 1 to several hundreds, all the way to several thousands. There’s nothing like a typical PE.

Another better approach for benchmarking the PE would be to look at the industry PE. So, let’s say for the IT industry, the average PE for industry is 25. A company with a lower PE than that can potentially (not necessarily) be undervalued.

Similarly, companies that have a PE of higher than 25 can potentially be overvalued. So don’t keep looking for an absolute number of PE and say that anything above 15 is overvalued and below that is undervalued. You need to analyse PE in the context of the industry.

Now at this point, a lot of people would be asking how do I really know whether a company is undervalued or overvalued?

Well, reading the PE ratio is more art than science and therefore, we will be explaining that in a separate video.

Important Points

Here are some important points that you have to keep in mind.

1) Generally speaking, higher the PE of a company relative to the PE of the industry, higher is the likelihood that it is overvalued.

2) Lower PE doesn’t necessarily mean that a company is undervalued and you should never go ahead and buy a stock just because it has a lower PE. What happens is more often than not, if a stock is trading at a lower PE, there might be a very good reason why investors are not confident in its growth prospects.

3) As an investor, we should not be looking for cheap stocks. We should be looking for great stocks at a bargain price.

4) Last point on the PE ratio is that it should not be seen in isolation. We need to take it as an input along with other criteria for stock selection.

So, I hope that this video gave you an introduction about PE, but there are more aspects to PE, which we’ll be covering in subsequent videos.

For example, we will discuss the 2 types of PE; Trailing and Forward and we’ll see how the two differ and which one is better. We will also do a comparative analysis of industry PE’s and above all, will also look at the overall market PE. So, there is a lot more to learn about PE and hence stay tuned for more videos on this topic and subscribe to this channel if you haven’t already.