Mr. Chaturvedi is a businessman and also takes keen interest in the stock markets. He has a varied portfolio of stocks which he tracks in his free time. He gets most of the investment tips by reading financial newspapers and through business news TV channels. Last week, there was a sudden dip in the stock index owing to which shares of a few known companies were available at a lower market price. One of the industry experts on one of the TV channels recommended a few shares for investment as they had a low P/E and were trading at a discount due to the market correction. Satisfied with the explanation and glad to have been able to time the market effectively, Mr. Chaturvedi promptly invested in the recommended shares.
Was he right in doing this or should he have done more research? Let us analyse this.
Price to Earnings Ratio is one of the important financial parameters fundamental analysts use for reviewing a company’s fundamentals.
P/E Ratio = Market price/Earnings per share.
In other words, this ratio tells us how much a share market investor is prepared to pay for the share relative to the company’s earnings. Since this ratio is calculated on the future projected earnings, the investor is actually buying in to its future earnings. But the P/E ratio cannot not be viewed as stand-alone and has to be considered along with other key indicators which are unique for each company.
A low P/E may not mean that the share is cheap, the P/E could be low because the company may be unlikely to replicate its past performance. Similarly, a high P/E doesn’t mean that the share is expensive as the P/E could be high because the company has very bright future prospects. In other words, a Rs 100 share may be reasonably valued, and a share of a company with a market price of Rs. 10 could be overvalued!
Hence it is very important to consider all the financial indicators of a company together to get the right perspective and identify and invest in value stocks.