Price to Earning Ration (P/E) is one of the most used ratios to evaluate the worth of a stock. The higher is the P/E ratio the more overvalued the stocks are and lower the P/E ratio the more undervalued the stocks are. But in order to effectively use the P/E ratio you need a basis on which you can compare two stocks. The first basis is “compare apple to apple: means in stock investment sense better compare two stocks of same sector. It means you cannot compare a realty stock with an auto stock.
Suppose a stock of auto sector has P/E ratio of 20 and another stock of the same sector has P/E ratio of 15, then it means that the later is undervalued as compared to the other. Lets take a real expample, consider two most traded share of Indian stocks market, (1) NTPC and (2) ITC. The current share valuation of these two companies is as tabulated below:
Values are not real but only an example
| NTPC | ITC |
Market Price (Rs) | 187.75 | 189.9 |
EPS Last Year (Rs) | 10.11 | 10.64 |
P/E Ratio | 18.57 | 12.39 |
| | |
CAGR of EPS over last 5 years | 10.50% | 6.00% |
As per the general understanding of the masses ITC, because of its low P/E ratio will be considered as undervalued than NTPC and most investors would prefer to buy ITC and avoid NTPC. Fundamentally both NTPC and ITC are exceptinal, so if one choses the shares just on basis of P/E ratio then they will select ITC. But getmoneyrich recommends that P/R ratio alone is not the best yardstick to select shares.
P/E ratio is a very strong investment ratio that values your stocks when compared with others. But alone P/E is does not give you a total picture. But there is a trick that can make P/E ratio very useful and almost complete for its users. How to do it? Investors would have to use the growth potential of this share and justify the extra price you pay for one share over the other.
We will see an expample where you will learn that though P/E ratio of ITC is lower but still NTPC is a better net for Investors. How? Lets see, now we will analyze the share by using the Growth Potential factor of the company. Simple divide the growth rate of earning of a company (compunded annually) over the last 5 years you will get a value called PEG ratio.
Values are not real but only an example
| NTPC | ITC |
P/E Ratio | 18.57 | 12.39 |
CAGR of EPS over last 5 years | 10.50% | 6.00% |
PEG ratio | 1.76 | 2.06 |
The lower the PEG ratio the better. A PEG ratio of 1 means there is a reasonable balance between the risk and return probabilities. The more that PEG ratio increses over 1 the more the risk factor increases as the stocks are becoming overvalued. PEG ratio below 1 means undervalued stocks.
Conclusion
The point is that a person must question himself that why investors are paying more for a particular stock (high P/E ratio) as compared to the other (low P/E ratio). The strongest fundamental basis of a company on which all investments are based is Net Profit/ Earnings of a company. If a company is able to grow its earnings at a rapid pace (like NTPC whose EPS was increasing at 10.5% per year for last five years) then investors will pay high price to grab this share. This is the reason why we suggests all its readers that focusing on both P/E ratio and EPS growth rate is important to select a value share.
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