H ave you ever experienced the following scenario: Aren't you disappointed at having to pay more for the same quality of apples? If you buy a share of company 'A' for Rs and later on find out that the share of company 'B', with better earning prospects, is available for Rs 60, it is bound to disappoint you.
So how do you find quality bargains? How can you decide if the current stock prices make sense? Does the price justify the earning prospects of the company? Introduction to PE ratio: PE ratio is one of the most widely used tools for stock selection.
It is calculated by dividing the current market price of the stock by its earning per share EPS. It shows the sum of money you are ready to pay for each rupee worth of the earnings of the company. Assume there are two companies 'A' and 'B', operating in the same sector. If PE of 'A' is 30 and PE of 'B' is 22, then 'B' is considered to be a better buy, as the market price has not gone up to reveal the earnings prospects of the company. But 'A' is considered to show higher growth prospects as compared to 'B'.
Understanding PE gives the investors an idea if the stock has sufficient growth potential. Stocks with low PE can be considered good bargains as their growth potential is still unknown to the market. If the PE is high, it warns of an over-priced stock. It means the stock's price is much higher than its actual growth potential. So these stocks are more liable to crash drastically. This was evident in the recent market crash when the stocks of all Reliance companies fell sharply.
Interpretation of PE ratio is heavily dependent on comparison of the company with its peers. Also PE that is considered very high in certain sectors can be considered very low in other sectors. For instance, companies in IT and telecom sectors have higher PE ratio than the companies in manufacturing or textile sectors. Also PE ratio is not totally neutral. Any major announcement of a major order or acquisition by the company will certainly push up its PE.
On the other hand, low PE may not indicate a good buy but could signify more serious issues facing the company. So it is very important to perform a thorough research into the background of the company, before investing. Besides EPS itself is assumed, as it forecasts future growth based on past performance. However, there is no guarantee that the company can continue to maintain its performance each year.
Also the sector in which the company is operating may experience problems as was recently seen for the IT sector. NewsApp Free Read news as it happens Available on. How it helps buy great stocks. India vs Sri Lanka, 3rd Test, Day 5. November was a good month for auto makers Any idea why economists don't write autobiographies? Which one should you buy?More...