HOW Effective IS PE Ratio PDF

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HOW Effective IS PE Ratio...

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HOW EFFECTIVE IS PE RATIO? The PE ratio is one of the most common and important metrics involved in stock market analysis. The PE ratio gives investors some indicator of valuation or how expensive a stock might be at a given point in time. But what is a good PE ratio? What is the range of PE ratios that warrants buying the stock? It’s a trickier answer than we might suspect because of all the variables and some of the limitations with the PE ratio itself.

Let’s first break down what exactly the PE ratio is. To get the PE ratio, we need to know the earnings per share (EPS) of the stock. Once we have the EPS, we can calculate the PE ratio by looking at PE ratio = Share Price / EPS. Let’s look at a simple example. If company ABC has $4.00 in earnings per share and its stock is trading at $40 per share, then we know the PE ratio is 10 since $40 / $4 = 10. Some investors view the PE ratio as a way to consider how many years of earnings we’ll need the company to generate in order to justify paying the current share price for the stock. In the previous example, since the PE is 10, we’re essentially buying the company at 10 times earnings. The PE ratio is basically the multiple of earnings we’re willing to pay for the stock. At a glance, the PE ratio tells us how expensive a stock is, and investors often use this valuation metric as part of the decision making process on whether or not to buy the stock.

Limitations of the PE ratio One of the main limitations of the PE ratio is the “quality” of the earnings. Sometimes earnings can be impacted by unusual or one-off gains or losses or other accounting mechanisms such as depreciation. The PE ratio does not tell us anything about a company’s debt position. Debt levels can impact a company’s financial performance, yet the PE ratio doesn’t indicate whether a company is debt free or bogged down by heavy debt loads. Another limitation of the PE ratio is the fact that PE ratio doesn’t tell us much about the company’s ability to grow revenues and earnings in the future. If we just look at the PE ratio

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by itself, we might quickly determine that a company trading at a 80 multiple against earnings is super expensive and that a company trading at 8 times earnings is very cheap. And we can be wrong in both scenarios. If the company with the 80 multiple is doubling revenue every year, that company might be trading pretty cheap, and the company trading at an 8 multiple might be shrinking and therefore actually be expensive. Again, we can’t look at nothing but the simple PE ratio and make a call on the stocks.

EXAMPLE SHOWING THAT PE RATIO IS NOT A GOOD INDICATOR OF WHETHER THE COMPANY IS OVERVALUEDA great example of a company’s share price not being affected by the PE Ratio is that of Netflix. Netflix delivers increasing amounts of revenue and subscriber growth, the stock has continued to move higher. Meanwhile, earnings have been pretty much flat and even random bumps in earnings from quarter-to-quarter are fairly meaningless.

As we can see in the above chart, Netflix’s PE ratio has been anywhere from 75 to 450 over the last 6+ years. If we were to purchase Netflix in March of 2013 when its PE ratio was around 450, we would have purchased the stock at around $23 per share (adjusted for splits). Our return as of end of March 2020, 7 years later, would have been almost 14x our investment with shares trading around $370. Sometimes, PE ratio will show we that a stock is overpriced and too expensive. However, if we never buy a stock that has a high PE ratio, in all likelihood, we’ll never own a stock that is a fast growing stock. If, we are sure of the future of a company and its ability to grow revenues many times over and lead to immense profitability down the road, letting a high PE ratio deter us from owning the stock is a mistake.

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Nifty PE analysis with Nifty PE Ratio vs Nifty Chart Nifty PE ratio is important as it is a measure of valuation of all the companies included in Nifty. From long term perspective, low Nifty P/E ratio is considered cheap and ideal for going long. A high Nifty PE multiple on the other hand is assumed to be expensive and warrants caution while taking investment decisions (Booking profit or going short is a better strategy than going long in High PE ratio scenario). The same can be depicted from studying the Nifty PE v/s Nifty chart below. When Nifty PE ratio is at its peak (in the range of 25 to 30), nifty is also at its peak and vice versa. It's clear from the chart above that stock market witnesses a sharp sell off when Nifty PE is near 25 and witnesses heavy buying when Nifty PE ratio is round 12 to 15.

The other alternatives for PE Ratio could be -

Using the PEG alternativeSome investors attempt to use the PE ratio alternative of the PEG ratio in order to attempt to address the PE ratio limitations around growth. The PEG builds upon the PE ratio, adds in growth estimates to give an indicator of how expensive a stock might be while also factoring in growth rates.

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So, a stock with a PE ratio of 15 that is growing earnings at a 15% growth rate will have a PEG of 1. If a stock has a PE ratio of 15 and is growing earnings at a 25% growth rate, it will have a PEG of .6. Finally, a stock that has a PE ratio of 15 and is growing earnings at a 10% growth rate will have a PEG of 1.5. So, we can take away from this that when PEG goes over 1, we’re starting to pay more for growth. When the PEG is under 1, we’re getting growth for a less expensive valuation. In general, we want a low PEG when buying a stock.

Using the CAPE ratioThe CAPE ratio (which stands for Cyclically Adjusted PE ratio) was created by a man named Robert Shiller and seeks to value the overall market using a modified version of the typical PE ratio formula. The CAPE ratio is calculated by taking share price divided by the 10-year average of inflation-adjusted earnings. CAPE uses a 10 year average in order to attempt to smooth out fluctuations in corporate earnings.

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Conclusion To sum up this PE ratio discussion, let’s go back to the original question: Is PE Ratio effective? The reality is that the answer is not an objective one, but more of a subjective one. There is no direct formula in investing where if we buy stocks at a certain PE ratio, it will result in a specific amount of return. Instead, the PE ratio is more about suiting our own investing style and philosophy. As we analyse stocks to purchase for our portfolio, understanding the PE ratio within the context of its industry, its growth rate and its competition definitely makes sense.

References 1. https://nextlevel.finance/what-is-a-good-pe-ratio/ 2. https://www.equityfriend.com/investment-charts/nifty-pe-chart-nifty-pb-chart-niftydividend-yield-chart.html 3. https://www.investopedia.com/articles/fundamental-analysis/10/should-you-trust-peratios.asp 4. https://www.investopedia.com/terms/p/price-earningsratio.asp 5. https://www.drvijaymalik.com/2016/08/3-principles-to-decide-investable-pe-ratio-of-astock-for-value-investors.html

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