The P/E Ratio: What, Why, How, etc.

What is P/E ratio?
P/E ratio of a company is defined to the price per share or equity of the company defined by Earning per Share (EPS). For example, consider a company which has 2million shares and the price of each share is 100. Suppose the company makes a net profit (or earnings) of 20million rupees in one year. Then the EPS of the company is equal to 2 (earning/number of shares) and the P/E ratio is equal to Price/EPS= 100/2= 50.

What is the P/E ratio good for?
The P/E ratio, along with expected growth and debt of a company are the three important number used to quickly 'estimate' the price of the company. There is no 'magic' formula which tells you what the 'exact' price of a stock or share must be, mainly because there is always a significant margin of error while estimating the growth prospects of a company. However below I will explain one possible way of quickly evaluating a rough price of a company. This may avoid you, as an investor, from investing in highly overpriced stocks.

How to evaluate the price using P/E ratio?
I have told you that P/E ratio, or Growth + EPS can be used to make a rough estimate of a stock.
However I did not tell how. One can write precise formulas and there will be several people who will have several different formulas. Later, if i see enough interest in the comments section I may upload a simple excel sheet which I use to estimate price using P/E ratio. However let me mention some thumb rules here. For example, some people simply equate P/E=growth in percentage. i.e. if a company is expected to grow at 10% per anum, it is worth 10P/E. That is, if such a company has EPS=5, then its fair price must be roughly equal to 50. If it is growing at 20% per anum then it is worth 20P/E. and so on... However this is just a rough way of estimating and let me mention some
Words of Caution
  • The Growth you use to calculate or estimate the price is NOT the past growth but the expected future growth which is sustainable. i.e. suppose a company has been growing at 40% per anum in the past, but its future prospects are grim and this growth is not sustainable, then you DO NOT use 40% in your calculation to estimate the price. You will first have to estimate the growth which is sustainable in the future years. THIS is the tricky part.
  • Debt of a company is important in evaluating the price of the stock. For example a company with high debt should be thought of as risky and a fair value of P/E for its stock will be lower than what it would be if the company was debt free.
  • While using EPS, or earning per share, one must always use Consolidated EPS and NOT standalone EPS. Read my post on Consolidated versus Standalone results to know more.
  • To calculate EPS, add net quarterly results of latest four quarters. i.e. suppose right now the latest results of the company available are those of the second quarter of 2009. Then to calculate EPS add net consolidated earnings per share of two quarters of 2009 and the last two quarters of 2008. Make sure the values of P/E you are looking at are actually up to date in this sense.
Where to find values of P/E ratio of Indian Companies?
Lots of places. You can find a list of some on my post Values of P/E, EPS, and B/V.

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Jan 15, 2009

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