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Do you wonder how long it will take to get back the same amount you have invested from your investment? You can find this out before investing using PE ratios!
Before we begin, imagine that you’ve made a bank FD worth Rs. 100 with interest rate 5.25% and you can’t touch this money for 1 year. One year later, you would have earned Rs. 5.25 in interest. Let’s call this your ‘earning’. Now, you gave Rs. 100 for the FD, obviously that’s your own Rs. 100, but let’s call this the ‘price’. If you divide this price with the earnings, you get a number close to 19. What this means is that you are paying Rs.19 to get one rupee in an interest payment. Essentially, you’ll take approximately 19 years to earn back Rs. 100 again. This is called the price to earnings ratio.
Let’s understand this ratio in relation to the stock market.
Welcome to our new series, Learn with Upstox!
I’m Aaditya Iyengar and in this series, we’ll be discussing some key aspects of fundamental analysis, corporate actions and some important general concepts about the stock market.
Let’s talk about the PE Ratio, what it tells us about an investment and how it’s calculated.
Let’s get started.
What is PE Ratio?
The Price to Earnings Ratio is probably the most important of all the financial ratios, when it comes to ratio analysis. A PE Ratio is when you take the price of a stock and divide it by the EPS, which is the earnings per share.
Now to calculate the EPS, you have to deduct all the company’s expenses, interest payments and tax from its revenue and divide this number by the total number of shares. The final number you get from this is the EPS. EPS tells us the profit per share.
What does a PE Ratio tell us about an investment?
A PE Ratio simply tells us how much money the market is charging for every rupee in a company’s profit. For example, if the EPS of a firm is Rs. 25 and its current share price is Rs. 500, we get a PE of 500/25, which is 20. This means, people are paying Rs. 20 to get every Re. 1 in the company’s earnings.
Many amateurs in the markets will say that PE around 18 is a good buy and one around 30 is a good sell. However, one can never decide if a given PE is too low or too high unless they compare that stock to its peers.
For example, the pharma sector is here to stay. People will need healthcare for as long as they’re alive. That’s the reason people are willing to pay a bigger price for pharma stocks. So, don’t be surprised if you see high PEs in the pharma sector. What matters is how the PE performs relative to its peers.
Always remember, you can’t take an investment decision only on the basis of PE ratio.
That’s it for now. Thank you so much for watching our video on PE Ratio, in our series, Learn with Upstox. I hope you learned something today.
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