"Company XYZ is available at a cheaper PE and is a good buy". You would have come across this phrase many a times in NDTV Profit or CNBC-TV18 or in the business newspapers. Most of us make an investment on recommendations from either friends/newspaper/TV channels and overlook technical parameters. Let us understand about these parameter and let me tell you it is not rocket science to learn these.
What is P/E Ratio?
P/E Ratio = Price of one share of a company/Earnings Per Share of the company.
Usually, EPS of the last four quarters is taken into consideration and the resultant P/E is called trailing P/E.If the expected EPS for the next few quarters is taken into account, we arrive at Forward P/E.
How to use P/E Ratio?
P/E Ratio can help investor take their decision to buy a stock. P/E indicates how much Rs is needed to generate a earning of Rs 1.
Eg. If P/E of company XYZ is 20, then it indicates, an investor is willing to pay Rs 20 to generate Rs 1 as earnings for the company.
P/E value varies across sectors. Banks have a lower P/E whereas the tail sector may have a higher P/E. Investors are willing to pay more for a retail company to generate earnings than they want to pay for Banks.
How to use P/E ratio along with other parameters?
As stated in one of the previous article, any technical parameter should not be considered alone to take a buy/sell decision. They should be analysed in conjunction with other parameters.
P/E ratio should be analyzed along with the growth rate of the company. If a company has a higher P/E ratio and but the future growth of the company is not very encouraging, then one should rethink on his decision to buy the stock. P/E of a company should be compared only with its peers. For eg, Infosys P/E should not be compared with SBI's P/E.
To reiterate, P/E should not be the only guiding factor to make your buy/sell decision. One should consider all factors affecting a stock's price before taking a call.