When a new investor steps into the world of stocks, the first thing that he hears is PE ratio.

“You should look for low PE stocks. They are a bargain!”

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“A PE of 10 isn’t that low. It’s a bear market. What can you expect?”

“Stay away from low PE. They are cheap for a reason.”

“The stock is selling for a PE of 60. I wouldn’t touch such an expensive stock with a pole.”

These were some of the things I was told by experienced investors when I started investing in the stock market 8 years ago. It was extremely confusing to me.

PE Ratio

Demystifying PE Ratio

What is PE Ratio?

I learnt that PE was a ratio of price to earnings. But what does it actually mean? Why do we need to deal with a ratio?

Usually, price determines if something is cheap or expensive, right? Then why do people use PE as a metric for valuation? Why can’t we just stick to the price?

Let’s understand this with a simple example. Imagine you are out for buying groceries. You enter a grocery shop and enquire about the price of onions.

“Rs. 100 per bag.” The fruit vendor replies.

“Oh! that’s expensive. The other fruit vendor is selling for Rs. 50 per bag.”

“I know. But his bag has only 1 kilogram of onions. I am selling 2 kilos per bag.” He clarifies.

You see, the price per bag doesn’t give you all the information. You need to ask how much per bag. Here, the “how much” is measured in weight, i.e., how much per kg.

“I know that. It’s common sense.” You might tell me.

I know. I was just making sure that we are on the same page.

Now, if you transpose that idea to stocks, you’d get an intuitive understanding of PE.

PE ratio is like the rate of a stock. Knowing only the price of a stock is incomplete information. You need to ask — how much am I getting for the price I am paying for this stock?

Question is, how much of what?

Earnings.

Earning is the measure of a company’s net profits. More specifically, earnings per share (EPS). Dividing company’s total net profit by total outstanding shares, you get EPS.

So, PE ratio tells you price per rupee of earning.

Today, Infosys is trading at a PE of 17. It means, when you buy one share of Infosys, you’re paying a rate of Rs. 17 for every rupee of earnings of Infosys. When you shell out Rs. 663 (current market price of INFY) to purchase one share, you’re effectively getting 663/17 = Rs. 39 of the company’s earnings.

Of course, the company won’t really pay you Rs. 39 as cash. Earnings aren’t really cash-in-the-hand for an investor. Dividends are.

Dividends are part of the earnings that the company decides to pay to the shareholders. In case of a fixed deposit (FD), the dividends and the earnings are same because all the earnings (interest) are paid out as cash. But let’s save the discussion of earnings vs dividend for another day.

Now that I mentioned FD, let’s try to wrap our head around this idea of PE by drawing an analogy between FD and a stock.

An analogy between fixed deposit and stock

What happens when you invest Rs. 10,000 in a bank FD @ 7 percent interest? It means we’re effectively buying an asset for Rs. 10,000 which generates a cash of Rs. 700 per year. Put another way, Rs. 700 is the earning (E) and Rs. 10,000 is the price (P). That makes the PE of our asset 10000/700 = 14.

In the case of FD, the earnings are pretty certain. And this certainty is at two levels. The amount of earnings and the surety of earnings.

A bank FD is considered safe because of the very high probability of returns. It’s also safe because the amount (7%) is also fixed.

In stocks, there is quite a bit of uncertainty at both levels, i.e., the amount of earning and the probability of the materialization of those earnings. And that’s why the PE of a stock keeps changing, unlike FD where PE remains fixed for the duration of the FD maturity period for the price and the earnings are both fixed.

So, comparing FD with a stock is like comparing Apples with Oranges. But it still helps a bit to get the understanding at the fundamental level.

When we were buying onions, there’s another parameter that we intuitively keep in mind. We also think about the quality when we pay the price.

As a high-quality onion would command a higher price per kg, a higher quality stock will command a higher PE. But judging the quality of a stock is much harder than estimating the quality of onions.

Beauty is in the eye of the beholder, goes the adage. True for quality too. Different investors have different opinions on the quality and the value of a given stock. Based on this, thousands of investors make buy-sell decisions in the stock market. This constant buy-sell activity is what makes the price of a stock change every minute.

There’s another thumb rule which helps in thinking about PE in the right way.

PE is the number of years it will take for you to recover your original investment. Infosys at PE of 17 tells us that Rs. 663 which we invested to buy one stock will come back to us in 17 years. Higher the PE longer it will take to get back our invested amount.

If you invert the PE, you get earnings yield. What is yield? It’s akin to the interest rate in FD.

In our FD example, when we inverted the interest rate you got the PE. Similarly, when you invert the PE of a stock you get earnings yield.

Please keep in mind that in the case of stocks, earnings yield is not the same as dividend yield. As I said, we’ll demystify the subject of earnings vs dividend some other day.

To become a better investor you need to have an intuitive understanding of PE ratio. I hope you found this post useful.

Please share your questions and feedback in the comments sections.

Happy Investing!