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.
We understand what Price to Earnings, or PE ratio is and how it is derived. (To understand the PE ratio better, please read “What is Price to Earnings (PE) ratio?“)
So, now its time to interpret it!
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
Low PE Ratio
A low PE ratio means that valuations are attractive. This means that the price of the stock is artificially low, and there is a high possibility of price of the stock going up. It is wise to buy such a stock.
But like High PE, here too, there is another possibility – it can also mean that the market expects the company to grow at a slower rate, or not grow at all. This is also true when the PE ratio of an entire sector is very low – it may mean that the sector in general would not grow as well as the other sectors. (For example, the current PE ratio of the Information Technology – IT – sector is lower than the PE ratio of many other sectors, because IT companies are not expected to grow as fast as companies in other sectors like Power, for instance).
I won’t repeat the example for Low PE, but the principle remains the same.
When the market expects a company to grow at a slower rate compared to its peers, or show a negative growth, it will give a lower PE ratio (or a lower market price for the stock) because the slow / negative growth in earnings (and in turn the slow / negative growth in the Earning Per Share or EPS) would ultimately bring the company’s PE to the sector average levels.
In conclusion, a low PE means either:
- The stock of the company is cheap, or
- People expect the company to grow slower than its peers, or show a negative growth
Rule 3: PE isn’t helpful in case of loss making companies
PE ratio might be totally irrelevant in case of companies just starting out, as they might not be making any profits. Same is the case for other loss making companies.
Since there is no or negative EPS, the PE ratio would also be negative, and would not convey much.
Rules of thumb
These are the general principles based on the PE ratios of companies currently being traded in the market.
Generally, companies in mature industries or markets have a stable and moderate growth rate. Such companies usually have a low to moderate PE ratio.
Companies in high-growth industries or markets show rapid growth. These companies usually have a moderate to high PE ratio.
Now that you know how to interpret the PE ratio, go ahead and try to find out why some companies are traded at a higher PE than others!!