Isn’t it disappointing to learn that the product you have just bought is not the worth of price or the same product is available at a much cheaper price in the shop located on the next street? Or rather you may find a much better product at a cheaper price.
Yes, this makes frustration reach its zenith.
But wait do you know the same thing can happen with buying of stocks?
Yes, and you need to analyze the actual worth of a stock. Here PE plays its role. It can help you analyze the actual worth of a stock and decide whether it’s right choice to buy or wait for the right time.
While analyzing the fundamentals of a company you will get to know there are lot many types of ratios that a company showcases in its balance sheet.
Among all of the PE ratio is one of the critical ratios that any investor be it immature or professional must not ignore.
It is known for its versatile significance that it contributes to evaluation of a stock
Price per earning ratio (PE ratio), as the name suggests is the company’s current share price to the company’s earning per share.
So, if PE is said to be 10. Then we can say that the stock price is 10x times its earning per share.
This particularly implies 2 important things.
- The market valuation of stock is 10 times its earnings
- As a buyer traders are ready to pay 10 times price of a value of stock in the market, so the market has valued the stock 10 times of its actual worth.
So what actually we need to find out with different values of PE..?
- When PE is HIGH
When PE is high, it suggests that market is bullish on that particular stock. The buyers are willing to pay more than the actual worth of stock. Here you can interpret it as the participants are expecting a good fortune of the company in coming future.
However, it’s not the only criteria of the actual valuation of stock and you need to verify it from other parameters too. In some cases, it may suggest that the stock is overpriced and if its fundamentals do not support its PE value then it may be a bubble that can burst anytime.
- When PE is LOW
When the PE is low, it suggests that the market has valued low than its actual worth. Basically here you can say that traders are not very sure about its earnings and stability in the coming future.
So the stock is undervalued. This also implies in some cases that the stock is underperforming at that period of time. This may be the best time to bargain a stock that may arise later and show significant growth potential.
The PE ratio varies from industries to industries. Some industries like diamond, fertilizers experience low PE while some like IT experience high PE. So it is advisable to compare PE among peers in same industry rather among industries.
So PE ratio cannot be considered to be a totally reliable indicator of cheap as well as good stocks.
Yet, PE ratio remains one of the most important ratios when it comes to stock selection