PE ratio as a Investing/Trading tool
As a market player I often see traders/investors around me putting money into the market when its doing really well. More often than not they end up buying stocks at the fag end of the rally. Also, they do not realize what is the right time to exit the long/buy positions. This is the biggest question for any medium to long term investor - When to buy and When to book profits?
In this post, I shall discuss the concept of Price Earning Ratio(PE Ratio) and how it can be used to make these decisions. To simply put it, PE ratio is Market Price of the share divided by the Earning per share of the company.
PE Ratio = Market Price per Share/Earning Per Share
or, Market Price per Share = PE Ratio x Earning Per Share
Lets say a company has EPS of Rs.10 and the Market price per share of Rs. 40. It means that for every rupee that the company earns, the investors are willing to pay Rs. 4 for it. Thus, PE Ratio of 4.
In the second formula above, you can see that the market price of share of any company is the product of EPS and PE ratio. The question arises - How do I know the PE ratio of a company and thus decide what should be the fair market price of that company? Well, this multiple is decided by the market itself. In fact, it is the Market Price of the share which is decided by the supply and demand forces in the market.Generally, a company with higher expected growth rate or let's say with greater clarity of earnings tends to trade at a higher PE valuations as compared to a company with lower growth rate.
Consider two companies A and B, both having EPS of Rs.10 each. Company A at a particular point of time has a market price of Rs. 40 whereas Company B has a market price of Rs.100 at the same point of time. The PE ratio of company A is 4 and that of B is 10. What can we say about the growth prospects of the two companies? Well, at least the market feels that company B will grow at a much faster pace as compared to company A.
But how should one use this concept of PE multiples while making investing decisions?
Different companies have different PE ratios. Also, different sectors too have different PE ratios. Stocks in the FMCG sector generally trade at higher PE valuations to something like financials or infrastructure stocks. This is because FMCG stocks are less prone to the ups and downs of the economy as compared to banking stocks which are cyclical in nature.
Irrespective of what the PE of a particular stock or sector is; we generally see them trading in range. Lets understand this taking the PE ratio of the Nifty 50 index. The current PE ratio of Nifty50 stocks combined is about 22.09 as on 6 Jan 2017. The chart below shows the range that the Nifty PE follows.
The broad range of the nifty PE is about 12 to 27 as can be seen above. A great time for any long term investor would be to enter the market/Nifty stocks is when the PE is on the lower end of this range and to simply exit or book profits when Nifty PE is close to the upper range. This is as simple as it can get for a medium term investor. One may get good returns in the market anyways in the longer term. But using PE ratio to decide when to enter and exit the market will certainly magnify ones returns.
What should an investor do at various levels of PE? This has been explained below:
NIFTY PE Investor Idea
24-27 There is Euphoria in the market. Even your panwadi
suggests you what to buy. Stay away from buying
and keep booking profits
20-23 Cheerful markets with scope of further profits. Keep
holding existing positions with stop losses. Not a
great time to take longer term bets.
16-19 Dull market with stocks trading at reasonable PE
valuations.Great time to start accumulating stocks
steadily.
12-15 Sell your car, sell your house and sell your kidney!!
And buy all quality stocks :D:D
Hope this helps. Cheers!
I really liked the blog. It had some interesting topics. Though I know about the P/E concept, but the Nifty P/E range was a new one for me.
ReplyDeleteQues: If the P/E of a company is more than the industry average. Is it a considered good from Fundamental and Investors point of view?
Hey Sameer,
DeleteThank you. As for your question, if a PE of a company as compared to its peers in the sector its generally a good sign. Market sees more growth for that company in the future.
A simple example can be TCS and Infy. Though the two are giant companies, TCS for several years always commanded a higher valuation of about 19 PE as compared to Infy at 15-16 odd. This was the phase when Infy was facing some headwinds in its US business.
Such trend is observed in generally all sectors. You would see HDFC bank, the most efficient large sized bank trade at premium valuations as compared to ICICI or SBI. Same goes for MRF tyres, which trades at a premium as compared to its peers like Apollo or Ceat Tyres.
You generally are willing to pay high price for a better quality product. (Like an Iphone ;)) Same logic goes for stocks too
Hope this helps.
Cheers
Hi Vikram,
ReplyDeleteThanks for the great insight. Even, I didn't know about the Nifty P/E and how it could be help an investor to decide when to enter or exit the market. Can we do the same classification for individual stocks after doing proper research as to what their historical PE's have been?
Hi Moksh
DeleteYes, this can certainly be done for stocks as well. Just like the Nifty, most large cap stocks follow a range of PE. The range becomes wider if the company is a smaller one. This is because the accuracy with which the the future earnings can be predicted is lower for small sized companies.
Hope this helps
Cheers
Hello fellow senior buddies although I am not an expert like you guys but still I have a doubt that can the PE stuff be applied to a particular sector of the market say pharma or fmgc or it must be applied including all the sectors simultaneously I mean for calculating that limit around 12 to 27
ReplyDeleteHi Gangesh
DeleteA lot of investors tend to identify stocks based on how cheap they are as compared to other stocks in the sector. If there is no reason to believe that there is a flaw with the company or its future potential, then it must trade at similar valuations as compared to other companies in the sector.