This article teaches you to interpret the PE ratio of a stock - depending on the growth of the company, the industry in which it operates, etc.

Rule 1: Compare

The most important thing to remember is that the PE ratio doesn't have any utility on a stand alone, isolated basis. This means two things:

- It should always be used to compare two companies, sectors, countries, etc.
- It should be used along with other tools of valuation and analysis

Rule 2: Compare Apples with Apples

When you are comparing, compare similar things. You can't compare the PE of a Refinery stock with the PE of an IT company. Similarly, you can't compare the PE of the Indian market (which is an emerging market) with the PE of American market (which is a developed market).

While dealing with companies, you usually compare the PE of the company with the average PE of the companies in that sector. You can also compare the PE ratios of two companies in the same sector.

Thus, when I say "High PE", I mean that the PE of the company is higher than the average PE ratio of the companies in the same league. Similarly, when I say "Low PE", I mean that the PE of the company is lower than the average PE ratio of comparable companies.

High PE Ratio

A high PE ratio means that valuations are stretched. This means that the price of the stock is artificially high, and there is a high possibility of price of the stock coming down. It is wise to sell such a stock.

But there is another possibility too - it can also mean that the market expects the company to grow at a very fast rate. This is also true when the PE ratio of an entire sector is very high. (For example, in the years 1999-2000, the PE ratios of the companies in the Information Technology sector were more than 100!)

Since this is a common occurrence, especially in a developing economy like India, let's examine this in greater detail.

As we know,

PE Ratio = Market price of the stock / its Earning Per Share

Now, the formula for PE ratio takes into account the current EPS. Should we consider the current EPS even for companies which are expected to grow very fast?

When we say a company grows fast, it means that its top line and therefore its bottom line grows fast. This also means that its EPS would grow fast.

Let's walk through an example, to understand this better.

Consider company ABC, which has:

Market Price = Rs. 800
EPS = Rs. 20

Thus, PE of company ABC = 800 / 20 = 40

The average PE ratio of the sector in which company ABC operates is just 15. Thus, company ABC definitely has a high PE.

Now, say the growth rate of company ABC is 50%. So, in the next year, its EPS should be Rs. 30. In the year after that, EPS would be Rs. 45, and so on.

If we find company ABC's PE ratio using the future EPS, it is:

For next year: PE = 800 / 30 = 26.67
For the year after that: PE = 800 / 45 = 17.78

So, when the market expects a company to grow at a fast rate, it is willing to have a higher PE ratio (or a higher market price for the stock) because the growth in earnings (and therefore the growth in the Earning Per Share or EPS) would ultimately bring the company's PE to the sector average levels.

Now this is not an exact calculation using an exact valuation model, but I am sure you get a general idea.

In conclusion, a high PE means either:

- The stock of the company is expensive, or
- People expect the company to grow faster than its peers

(Continued on the next page...)

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Note: Please treat the opinion expressed here as a broad suggestion. Please consult your financial planner / investment advisor before making any investment decision.