“It’s a screaming buy at 12 times PE!” Or “I wouldn’t touch it with a barge pole at 85 times PE.” If you have been dabbling in stocks, you are bound to have heard such remarks made by other investors. So, what is this magic number that decides the fate of a stock?
Mathematically, PE or price to earnings ratio is calculated by dividing the stock’s prevailing market price by its earnings per share (EPS). This implies the price an investor is willing to pay for the earnings delivered by the stock or company. Let us assume that a company ABC reported an EPS of ₹100. The market price of the stock is ₹1,000. This would imply a PE multiple of 10 times; in other words, investors are willing to pay a price that is 10 times ABC’s earnings capacity.
What decides this multiple? The sector in which the company operates, market presence, business model, management and earnings performance or visibility.
Hence, high quality stocks with strong business model, dominant position and strong earnings visibility can command a high PE multiple, as they turn out to be market darlings. Investors flock to buy such stocks, pushing up their market price and hence, the PE multiple.
On the other hand, investors are particularly unkind to companies or sectors that are riddled with challenges or have had a lacklustre earnings show. Naturally, these stocks command a far lower PE multiple.
Different flavoursThe most commonly used form of PE is the trailing PE which is computed by dividing the market price by the earnings per share reported by the company in the past. Mostly, the earnings of the last 12 months is taken into consideration. Here, a lot of emphasis is placed on the past performance of the company.
But what if a company is just turning the corner after a long spell of underperformance? Wouldn’t you want to give it the benefit of doubt?
Forward PE that takes into account the estimated earnings of the company, say one or two years hence, helps investors factor in their expectations of the company’s future performance — good or bad.
So, what’s the minimum or maximum one can pay for a stock in terms of PE multiple?
Sector variationsThat’s hard to ascertain, given that expectations are aplenty and varied in the market. But usually, cash-rich companies with high return on equity (ROE) trade at far higher premium to other stocks in the market.
Sectors that are very easily impacted by regulatory changes or the political scenario are valued differently. Export-oriented companies or those linked to global events carry different risks and are valued accordingly.