P/E Ratio

P/E is short for the ratio of a company's share price to its per-share earnings. As the name implies, to calculate the P/E, you simply take the current stock price of a company and divide by its earnings per share (EPS)

P/E Ratio = Market Value per Share
Earnings per Share (EPS)

EPS = Profit After Tax (PAT)
Number of shares in the share capital

The common sense would dictate that lower P/E ratio means that the price is undervalued and higher P/E ratio means that the price is overvalued.

It's difficult to determine whether a particular P/E is high or low without taking into account two main factors:

1. Company growth rates - How fast has the company been growing in the past, and are these rates expected to increase, or at least continue, in the future? Something isn't right if a company has only grown at 5% in the past and still has a stratospheric P/E. If projected growth rates don't justify the P/E, then a stock might be overpriced. In this situation, all you have to do is calculate the P/E using projected EPS.

2. Industry - It is only useful to compare companies if they are in the same industry. For example, utilities typically have low multiples because they are low growth, stable industries. In contrast, the technology industry is characterized by phenomenal growth rates and constant change. Comparing a tech company to a utility is useless. You should only compare high-growth companies to others in the same industry, or to the industry average.

One can only make sense of a P/E number of a particular stock by
comparing it with P/E of other companies in the same line of business
comparing it with the benchmark indices say Sensex P/E or Mid-cap P/E
assessing the growth potential of the industry
assessing the growth potential of the particular company

Let's look at a couple of cases - Banking & IT. Banking as an industry enjoys an avg P/E of around 8-10 visa IT, which enjoys PE exceeding 25-30. The reason is simple - growth.

In a normal scenario the profits of a bank are the spread it earns between the interest rates on deposits and lending. And this usually varies between 2-4 per cent. If the interest rates on deposit go up, the lending rates will also go up and vice versa. Therefore, the profit potential of a bank is limited. And hence the P/E ratio for banks is usually below 10. The only option for a bank to grow is by increasing the asset size.
Banks like HDFC and ICICI are rapidly increasing their asset base every year vis-à-vis the nationalised banks. Hence, they enjoy much higher P/Es of 20-25.

On the contrary most IT companies are growing at 30-40 per cent p.a. Therefore, in anticipation or likelihood of such high growth rates, the P/E ratios of 25-30 are not unreasonable even for average IT companies. The larger and better companies may even enjoy P/E in excess of 30-35.

Most of the time, the P/E is calculated using EPS from the last four quarters. This is also known as the trailing P/E. However, occasionally the EPS figure comes from estimated earnings expected over the next four quarters. This is known as the leading or projected P/E. A third variation that is also sometimes seen uses the EPS of the past two quarters and estimates of the next two quarters. There isn't a huge difference between these variations. But it is important to realize that in the first calculation, you are using actual historical data. The other two calculations are based on analyst estimates that are not always perfect or precise. Companies that aren't profitable, and consequently have a negative EPS, pose a challenge when it comes to calculating their P/E. Opinions vary on how to deal with this. Some say there is a negative P/E, others give a P/E of 0, while most just say the P/E doesn't exist. Historically, the average P/E ratio in the market has been around 15-25. This fluctuates significantly depending on economic conditions. The P/E can also vary widely between different companies and industries.

Using The P/E Ratio
Theoretically, a stock's P/E tells us how much investors are willing to pay per dollar of earnings. For this reason it's also called the "multiple" of a stock. In other words, a P/E ratio of 20 suggests that investors in the stock are willing to pay $20 for every $1 of earnings that the company generates. However, this is a far too simplistic way of viewing the P/E because it fails to take into account the company's growth prospects.

Growth of Earnings
Although the EPS figure in the P/E is usually based on earnings from the last four quarters, the P/E is more than a measure of a company's past performance. It also takes into account market expectations for a company's growth. Remember, stock prices reflect what investors think a company will be worth. Future growth is already accounted for in the stock price. As a result, a better way of interpreting the P/E ratio is as a reflection of the market's optimism concerning a company's growth prospects.
If a company has a P/E higher than the market or industry average, this means that the market is expecting big things over the next few months or years. A company with a high P/E ratio will eventually have to live up to the high rating by substantially increasing its earnings, or the stock price will need to drop. A good example is Microsoft. Several years ago, when it was growing by leaps and bounds, and its P/E ratio was over 100. Today, Microsoft is one of the largest companies in the world, so its revenues and earnings can't maintain the same growth as before. As a result, its P/E had dropped to 43 by June 2002. This reduction in the P/E ratio is a common occurrence as high-growth startups solidify their reputations and turn into blue chips.

Problems With The P/E
Accounting
Earnings is an accounting figure that includes non-cash items. Furthermore, the guidelines for determining earnings are governed by accounting rules (Generally Accepted Accounting Principles (GAAP)) that change over time and are different in each country. To complicate matters, EPS can be twisted, prodded and squeezed into various numbers depending on how you do the books. The result is that we often don't know whether we are comparing the same figures, or apples to oranges.

Inflation
In times of high inflation, inventory and depreciation costs tend to be understated because the replacement costs of goods and equipment rise with the general level of prices. Thus, P/E ratios tend to be lower during times of high inflation because the market sees earnings as artificially distorted upwards. As with all ratios, it's more valuable to look at the P/E over time in order to determine the trend. Inflation makes this difficult, as past information is less useful today.

Many Interpretations
A low P/E ratio does not necessarily mean that a company is undervalued. Rather, it could mean that the market believes the company is headed for trouble in the near future. Stocks that go down usually do so for a reason. It may be that a company has warned that earnings will come in lower than expected. This wouldn't be reflected in a trailing P/E ratio until earnings are actually released, during which time the company might look undervalued.

It's Not A Crystal Ball
What goes up ... well, sometimes it stays up for an awfully long time. A common mistake among beginning investors is the short selling of stocks because they have a high P/E ratio. Short selling is an investing technique by which an investor can make money when a shorted security falls in value. Although a high P/E ratio could mean that a stock is overvalued, there is no guarantee that it will come back down anytime soon. On the flip side, even if a stock is undervalued, it could take years for the market to value it in the proper way. Security analysis requires a great deal more than understanding a few ratios.

The short-term outlook
Liquidity, demand-supply scenario, political uncertainties, budget, corporate announcements etc are some of the factors, which affect the price of a stock in the short-term. Suppose there is good news flow for the steel industry. Then practically all the steel stock prices will move up even though some of these companies may not be performing too well. Therefore, buying and selling in the short-term is more of a trading call than an investment call. It is suited more for a person who can invest his time daily to the stock market.

The long-term outlook
The real benefit of investing in equity markets accrues through long-term investing. Hence it is more pertinent to understand the stock valuation from a long-term perspective.
In the long run, the price of a stock is the reflection of the operational performance of the company. The expected growth and future profits will determine the price. And because we have to take a view on the future prospects of the company, the industry and the economy in general, assessment of the 'right price' becomes difficult, subjective and prone to large volatility depending on how the future unfolds.

Therefore, one should keep in mind that:
There no concept of an absolute right PE
It is quite normal to invest in a high growth industry like IT with P/E of say 20, but not so for a low growth industry like bank
A low P/E vis-à-vis the industry average (e.g. Bank A is quoting at 3 PE as compared to the average of 8 PE for the banks) does not necessarily mean it is cheap. The PE may be low because the bank is having some problems and hence may not be expected to do well in the future.
The P/E number requires careful analysis. Only then can one assess the over or under-valuation of a stock and decide on the investment worthiness of the stock.