What is good P/E ratio ? Invest In High P/E Or Low P/E Stocks

Price to earnings ratio (P/E)

Overvalued Or Undervalued??? 

Most common and wrongly interpreted term in the finance industry.

Let us understand the concept of P/E

  If the P/E is higher than that of comparable firms, it is said to be relatively overvalued, that is, overvalued relative to the other firms ("Not necessarily overvalued on an intrinsic value basis"). The converse is also true: if the P/E is lower than that of comparable firms, the firm is said to be relatively undervalued  ("Not necessarily undervalued on an intrinsic value basis").

Price to earnings is the ratio which shows how much respect the market is giving to a particular company for his future potential. Example: If P/E is 20 it means i am ready to pay 20 rs for every 1 rs earnings.

Let’s move on a case study to understand the concept .

Industry - Information Technology.

Company A - P/E 20,  Sales - 100 Lakhs, Profits- 20 Lakhs

Company B - P/E 80 , Sales -100 Lakhs, Profits -20 Lakhs

Both have the same sales and profits margin.

 

Which one will you buy? Most retail investors will prefer to buy company A right?  Simply, because it is cheap.

Here the twist begins.

Company A - Debt 5 times, No. of shareholder 60 Lakhs, EPS 10, Face Value 10

Company B- Debt free, No. of shareholder  40Lakhs, EPS 5, Face Value 1  

 

Now you will better understand why Company B has been given more respect by the market than that of Company A. Why it is charging a high premium!

If we interpret the above data we will find.

Company A- ROE 33%, Debt to Equity 5:1, EPS 10

Company B- ROE 50%, Debt free, EPS 50

 

These are the only few parameters which forces the company to charge high P/E there are many more which I will touch on latter blogs.

Now many of you might be thinking why I have written EPS of 50 in the case of Company B. It is another concept of face value let's look at it also.  

 

To compare the EPS of companies it is necessary that they should be at the same face value. Only after that an EPS can be compared. We could also adjust the EPS of  Company A on face value basis i.e EPS might be 10/10 = 1 in the case of Company A.  It is totally up to you, you just have to make the face value equal.

 I hope you have received the answer. I will invest the company which is undervalued in terms of intrinsic value not in terms of price to earnings. 

Investor Choices