All about P/E ratio

When you are evaluating a company for its value from an investment perspective one ratio that everyone looks for and talks about is P/E. You will see everyone referring to it and talking about it in the equity markets. Here are some answers to common questions -

What is the P/E ratio?: P/E stands for Price to Earnings ratio. It is the price of an equity share of the company divided by the earnings of the company against each equity share. Let us look at each of these parameters in detail.

• Price of an equity share (P): This is the prevaling price of the equity share of the company in the market today. Pls note this is different from the face value of the share of the company. A share of face value 10 may be priced at a premium to (above) the face value or at a discount to (below) the face value.
• Earnings per share (E): It is calculated as the profit earned for the most recent 12 month period per each outstanding share. For example if a company makes a profit of 100,000 and has 1000 shares outstanding, the earnings per share are 100.

What does P/E denote?: From a financial perspective one would like to pay a price for an investment equivalent to the profit (earnings) that can be derived from the investment. So ideally one would like to have a P/E of 1. Since the earnings of a good company are bound to grow (increase), one might want to pay a price greater than the current earnings of the company. So the P/E becomes > 1. If the company is not making any profit, or making a loss for that matter P/E becomes < 1. So essentially P/E denotes what the market thinks of the company's growth prospects. If it is a high growth company one would like to pay a steeper price than the current earnings and if the company is low or medium growth then obviously the price will be lower. Also if the company is growing its earnings quickly the P/E will become low. Obviously then a lower P/E denotes a value investment (value investments will be covered in a later blog).

What is the right P/E?: There is no one number that can be specified as the appropriate P/E for a company. Various factors like business environment, economic growth rate, regulations, demand, projected growth rate, etc. contribute to the determination of what one feels as the correct P/E for an investment. Since its a ratio of Price to Earnings, lower the value, the cheaper the company is to own.

Word of Caution: Know that the P/E can be manipulated! Since the concentration is on lowering the P/E ratio, it can be manipulated by increasing the denominator. Lets say company X has 1000 shares outstanding at a price of 800 per share and earnings of 100,000. Current P/E of company X is 800/100=8. Now company X decides to buy back 200 of its shares at 800. The new P/E of X is 800/125=6.4! So even though the company did not actually grow its earnings, it managed to lower its P/E just by buying back its shares!