POINTS TO KEEP IN MIND DURING GD-PI:
Keep them coming because from GD-PI point of view, these terms are important.
The Price/Earning ratio or the PE ratio is the term commonly used to assess the fairness of the stock price.
PE ratio is defined as the ratio of market price to earning per share (EPS).
PE ratio = Market price of the share
Earning per share (EPS)
EPS in turn = Profit After Tax (PAT)
Number of shares in the share capital
The common sense would dictate that lower P/E ratio means that the price is undervalued and higher P/E ratio means that the price is overvalued. Unfortunately, it is not true.
In absolute terms there is no ‘right’ PE. One cannot say that PE of a stock of say 10 or 15 is good or bad.
One can only make sense of a P/E number of a particular stock by
a) comparing it with P/E of other companies in the same line of business
b) comparing it with the benchmark indices say Sensex P/E or Mid-cap P/E c) assessing the growth potential of the industry
d) assessing the growth potential of the particular company
Let’s look at a couple of cases – Banking & IT - to get a better appreciation of the P/E number. Banking as an industry enjoys an average P/E of around 8-10, vis-à -vis IT, which enjoys PE exceeding 25-30. The reason is simple – growth.
In a normal scenario the profits of a bank are the spread it earns between the interest rates on deposits and lending. And this usually varies between 2-4%. If the interest rates on deposit go up, the lending rates will also go up and vice versa. Therefore, the profit potential of a bank is limited. And hence the P/E ratio for banks is usually below 10. The only option for a bank to grow is by increasing the asset size. Banks like HDFC and ICICI are and rapidly increasing their asset base every year vis-Ã -vis the nationalised banks. Hence, they enjoy much higher P/Es of 20-25.
On the contrary most IT companies are growing at 30-40% p.a. Therefore, in anticipation or likelihood of such high growth rates, the P/E ratios of 25-30 are not unreasonable even for average IT companies. The larger and better companies may even enjoy P/E in excess of 30-35.
Therefore, one should keep in mind that
1) There no concept of an absolute right PE
2) It is quite normal to invest in an high growth industry like IT with P/E of say 20, but not so for a low growth industry like bank
3) A low P/E vis-Ã -vis the industry average (e.g. Bank A is quoting at 3 PE as compared to the average of 8 PE for the banks) does not necessarily mean it is cheap. The PE may be low because the bank is having some problems and hence may not be expected to do well in the future.
Source- ASHJNDL FORUM
Keep them coming because from GD-PI point of view, these terms are important.
The Price/Earning ratio or the PE ratio is the term commonly used to assess the fairness of the stock price.
PE ratio is defined as the ratio of market price to earning per share (EPS).
PE ratio = Market price of the share
Earning per share (EPS)
EPS in turn = Profit After Tax (PAT)
Number of shares in the share capital
The common sense would dictate that lower P/E ratio means that the price is undervalued and higher P/E ratio means that the price is overvalued. Unfortunately, it is not true.
In absolute terms there is no ‘right’ PE. One cannot say that PE of a stock of say 10 or 15 is good or bad.
One can only make sense of a P/E number of a particular stock by
a) comparing it with P/E of other companies in the same line of business
b) comparing it with the benchmark indices say Sensex P/E or Mid-cap P/E c) assessing the growth potential of the industry
d) assessing the growth potential of the particular company
Let’s look at a couple of cases – Banking & IT - to get a better appreciation of the P/E number. Banking as an industry enjoys an average P/E of around 8-10, vis-à -vis IT, which enjoys PE exceeding 25-30. The reason is simple – growth.
In a normal scenario the profits of a bank are the spread it earns between the interest rates on deposits and lending. And this usually varies between 2-4%. If the interest rates on deposit go up, the lending rates will also go up and vice versa. Therefore, the profit potential of a bank is limited. And hence the P/E ratio for banks is usually below 10. The only option for a bank to grow is by increasing the asset size. Banks like HDFC and ICICI are and rapidly increasing their asset base every year vis-Ã -vis the nationalised banks. Hence, they enjoy much higher P/Es of 20-25.
On the contrary most IT companies are growing at 30-40% p.a. Therefore, in anticipation or likelihood of such high growth rates, the P/E ratios of 25-30 are not unreasonable even for average IT companies. The larger and better companies may even enjoy P/E in excess of 30-35.
Therefore, one should keep in mind that
1) There no concept of an absolute right PE
2) It is quite normal to invest in an high growth industry like IT with P/E of say 20, but not so for a low growth industry like bank
3) A low P/E vis-Ã -vis the industry average (e.g. Bank A is quoting at 3 PE as compared to the average of 8 PE for the banks) does not necessarily mean it is cheap. The PE may be low because the bank is having some problems and hence may not be expected to do well in the future.
Source- ASHJNDL FORUM
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