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What is P/E ratio?why it's important to be check for investing

Investing in equity market is risky so it is important to check various aspects to check the financial health of the company and make sure that it is suitable or not as every individual investor have different future plans, return expectations and risk bearing capability.

Most of the investors prefer to take the help different financial ratios for fundamental analysis. There are so many financial ratios such as ROE,EPS, P/B, P/E, Debt/equity ratio etc which are used by many investors for their study. 

From these ratios P/E ratio is very important to check the financial position of the company and future scope of the company. It is used for the proper valuation of the stock. 

Today we're going to explain what is P/E ratio and why it is so important for investment point of view. 

What is P/E ratio?





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What is P/E Ratio? 


Basically, P/E ratio is calculated by dividing share price by its EPS i.e.

P/E = share price/ Earning per share

Before, understanding the P/E ratio we have to understand what is EPS. As name sounds EPS indicates how much an investor earned by holding 1 share of the company. 

Now, we understand what is P/E ratio/ what P/E ratio indicates? 

P/E ratio indicates how much an inverstor have to pay to earn Rs 1 from 1 share of the company. 

Suppose, Share price of company ABC Ltd. is 100 and its EPS is 20 than P/E ratio will be, 

P/E = 100/20 i.e. 5

It means that to earn Rs 1 an investor have to Rs 5.

Now, you think that low P/E stocks are better than high P/E stocks as you have to pay less to earn. This not real. 

Now, a question arise why investors pay more to earn less? 

This is because investors believes that company will give them better return in future. So, today they are willing to pay more. 


Reasons for High P/E:


1) Continuous Rise in Profits:


If a company is continuously showing good results and rise in profit it motivates the investors to invest in the company. Which results in rise in share price and ultimately rise in company P/E.

2) Return on Equity (ROE) :


This is another important financial ratio which is consider by the investors by taking any investment decision. This ratio indicates how the company utilize the shareholders funds. Normally, the companies which are utilizing shareholders funds properly and making profits have high ROE. The investors preferred to invest in such company. So, the P/E that company also high. 

3) Favourable news:


Favourable news like favourable government policy aur company gets big projects also leads to increase in demand for the company shares in the market. Which ultimately leads to high P/E ratio. 

4) Promotors Holdings:


P/E ratio is also affect due to promotors holdings. If promotors holdings are continuously increasing in the company it means they have much faith in future plans and future growth of the company. This attracts the investors to invest in the company which results in high P/E.

In opposite, if they continuously decreasing their holdings in the company or percentage of pledging of share is indicates promotors have no much faith on future growth of the company so they decreasing their holding from  the company. Which have negative impact on the shares and leads to fall in share price and ultimately results in low P/E.


How to check company is overvalued or undervalued? 


You can compare the P/E ratio of the company by its sectors P/E than you will get some idea about wether the stock is overvalued or undervalued. But it is just an idea not the truth. 

e.g. Tata Consultamcy Service   P/E: 36.42 

        Industry  P/E : 30.49

As shown above TCS P/E is greater than industry P/E is it mean TCS is overvalued? 

No, it deserves its position. When all the sectors companies are falling TCS is still paying good returns to its shareholders. Also, company is continuously growing its business and showing amazing results. It has given tremendous returns to its shareholders. The shareholders are really willing to pay more for company's shares. 

 

Like, stocks P/E you can check stock market P/E also. You can check it by typing NSE PE ratio today on google. This will redirect to official website of NSE. You check it here https://www1.nseindia.com/products/content/equities/indices/historical_pepb.htm

Basically, the stock market P/E between 10 to 30. If market is near to 10 it means market is at low level and this is the right time to buy the shares. 

And if Nifty P/E ratio is near to 30 it means market is overvalued and a small bad news can crash the market. 

Todays P/E ratio of Nifty is 29.22. As market is at its top level a small news can become a cause of fall in market. So, think twice before investing. 

Closing Thoughts:


P/E ratio is a good tool but before taking any decision you should look on other prospects like management,assets and liability, financial results, shareholding patterns, future scope of business, competition etc. 

I hope you understand what is P/E ratio and its importance while investing. If you have any query write in comment box. 










                          
 
                    




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