Financial ratios are used by most investors to find stocks of companies that are fundamentally strong. Some commonly used ratios are Profit-to-Earnings (P/E) ratio, Debt-to-Equity (D/E) ratio, Profit-to-Book (P/B) Ratio, etc.
These ratios are used by investors to choose the right stock for investing based on their investment plan and preferences. Today, we are going to talk about one of the most common ratios used by investors – the P/E ratio. There is a popular belief that a stock with a high P/E ratio is a good buy. We will explore the truth behind this belief and offer some tips to keep in mind before investing in high P/E stocks.
Understanding the P/E ratio
P/E ratio is the ratio of the share price of a company’s stock to its earnings per share (EPS). Mathematically,
P/E Ratio=Share price/Earnings per share (EPS)
Earnings per Share or EPS is the ratio of the total earnings of a company to the number of outstanding shares. Mathematically,
EPS=Overall earnings of the company/Total number of outstanding shares
The P/E ratio can help you understand if the market price of a share is in accordance with the company’s earnings. Let’s look at an example to understand it better:
A company, ABC Ltd., has 5 lakh outstanding shares. The market price of each share is Rs.200. Further, in the current financial year, the company has overall earnings of Rs.50 lakh.
Let’s calculate the earnings per share first.
Next, let’s calculate the P/E ratio.
In simple terms, this means that currently, investors are paying Rs.20 to get a Re.1 share in the earnings of the company. Why would investors do that? Let’s find out.
What is a High P/E Ratio?
As we saw in the example above, investors were paying Rs.20 to get a Re.1 share in the earnings of the company. This can happen if investors are certain that the company will generate more profits in the future. Hence, the demand for the stocks of the company increases, and its price rises too, allowing them to earn capital appreciation along with regular income in the form of dividends. Hence, the P/E ratio is a good way to get a glimpse into the way the market is perceiving a specific stock.
However, P/E ratios are not standalone measures. In fact, every industry or sector can have different P/E ratios. Hence, there is no standard measure of a high P/E ratio. It is always in comparison with the company’s competitors and peers. If you look at the FMCG sector, most companies have a P/E ratio between 25 and 50. If ABC Ltd. (from the example above) belongs to the FMCG sector, then its P/E ratio is very low. However, if ABC Ltd. belongs to the Paper Industry where the average P/E is between 5 and 8, then the P/E ratio of ABC Ltd. is high.
Factors that Lead to a Higher P/E ratio
Since a P/E ratio talks about the relationship between the stock price and earnings of a company, it is important to understand the aspects of the company’s financials that lead to higher P/E ratios in companies:
- Consistent growth in earnings – People like to invest in stocks of companies that are consistent in their performance and have a growth trajectory and earnings that are reliable and sustainable. Therefore, companies that offer a consistent growth in earnings are preferred and investors pay more to get a share in their earnings.
- Profitability – While growth is good, not all companies successfully convert growth into profits. Hence, companies who display efficiency in this aspect are preferred and have a higher P/E ratio.
- ROE – This is another financial ratio that many investors consider before making a decision. This tells them if a company can efficiently convert shareholder equity into profits. Usually, companies with higher ROE ratios are preferred by investors especially if they have low debts. The P/E ratio for such companies tends to be higher too.
- External conditions – Macroeconomic conditions impact the entire stock market. Hence, certain policy decisions or macroeconomic situations can cause the price of a stock to increase leading to a boost in its P/E ratio.
Things to Keep in Mind Before Investing in High P/E Stocks
As you can see, stocks with higher P/E ratios seem like better investment options. However, you cannot merely rely on the P/E ratio to make an investment decision. Here are some essential things that you must keep in mind before you invest in a high P/E stock:
1. The Stock Can be Overvalued
Since P/E is a ratio, a higher numerator or lower denominator can result in a higher P/E. Hence,
- The Numerator (Share Price) – If the market price of a stock increases due to reasons beyond the performance of the company, then the P/E ratio will be higher. However, it might not resonate with the company’s performance and the demand might not be sustained for long.
- The Denominator (EPS) – EPS is the ratio of the earnings of a company to its outstanding shares. If the company issues more shares, then its EPS can drop. This can boost the P/E ratio of the company. Also, if the company has lower earnings in a financial year, then its EPS will be low causing a higher P/E ratio.
Typically, most investors analyze the popularity and demand of a stock by looking at the company’s P/E ratio in comparison with its peers. However, as you can see above, a company with lower earnings can also have a higher P/E ratio and be overvalued. Hence, it is important to understand all aspects before investing.
2. Price Volatility
The stock market is inherently volatile. Since the P/E ratio depends on the market price of the share, when external factors turn markets volatile, the stock price becomes volatile too. This makes it difficult to get a steady P/E ratio. Hence, avoid using the P/E ratio to assess the demand for a stock during highly volatile market periods.
3. Dig Deeper
A high P/E ratio can be a good indicator of a company with good growth prospects. However, it is not enough to look at the P/E ratio alone. Ensure that you analyze the financials and fundamentals of the company and its competition to determine its growth prospects. This can help you make a more informed decision.
There are certain risks associated with investing in stocks purely on the basis of higher P/E ratios:
1. Avoid Investing in a Business You Don’t Understand
While there are several tools and financial ratios to help analyze a company’s strength and the subsequent benefits of investing in its shares, it is important to remember that the market price of a share is not governed by the performance of the company alone. External factors like the political, social, economic, etc. have a bearing on the stock price too. Therefore, before investing, it is important to understand the business of a company, its competition, and its position in the market. Remember, never invest in a business that you can’t understand. Look at all aspects of the company before making a decision.
2. Don’t Avoid Fundamental Research of the Company
The popular opinion about stocks with high P/E ratios is that they are excellent investment options since investors are willing to pay more for a smaller share in the company’s earnings. Hence, they presume this to be an indicator of an optimistic investor perception towards the stock.
But, you must remember that P/E can be higher because of a range of reasons not necessarily related to its performance. Hence, the fundamental analysis of the company should not be ignored.
While looking for a stock with a higher P/E ratio than its peers can be a good place to start, investors must try their best to avoid the infamous P/E trap. While the P/E ratio can help you get a good idea of the demand for a particular stock in the market, ensure that you keep the above-mentioned points in mind before taking the plunge.