What does a P/E ratio signify?
A P/E (Price to Earnings ratio) is defined as ratio of the current market price of a company’s share to the earnings per share of that company. In simpler terms, it captures the amount of money an investor is willing to pay in a single share in rupee against an earning of Re.1 from that share. The higher the P/E ratio, the greater the value ascribed to that particular share in terms of overall growth and future revenue-generating potential. Hence, the higher the present value of the share. On the contrary, a lower P/E ratio would mean muted growth prospect of the share and lesser money invested for Re.1 of earnings. Another way to interpret a company with a high P/E ratio is that the shares are overvalued and may result in saturation of growth in future while a lower P/E ratio is an indicator that the stock is under-performing and the company might grow in the long run if fundamentals are strong. A portfolio having shares from the same industry with a higher P/E ratio will have a higher return on equity (ROE) and vice-versa.
Types of P/E ratio:
Forward P/E ratio: The ratio is calculated based on the current share price and future earnings potential which is an output of future earnings guidance
Trailing P/E ratio: This ratio is obtained by dividing the current share price by the past earnings thereby resulting in a more realistic metric of investment.
Both approaches have certain limitations and should not be the only basis of your decision while doing a portfolio valuation or planning systematic investment in equity mutual funds where individual shares need to be analysed. Future earnings guidance in the Forward P/E ratio has sensitivities embedded in it with respect to the degree of speculation. A trailing P/E ratio is again based on the current price and past earnings which are again not like-to-like scenarios and it does not provide a concrete picture of the future uncertainties and headwinds.
The disconnect between the P/E ratio and Value Investing:
The importance of value investing is critical if you want to maximize the returns from your investment portfolio be it in shares or systematic investment in mutual fund schemes. Conventional wisdom suggests a direct correlation between a higher P/E ratio and future earning potential. It reinforces the idea that investors will continue to generate higher revenue streams and financial growth in the future. While the reverse would be true for shares with a lower P/E ratio. But the reality may be completely different. Value investors always look at the fundamentals before investment. A very high P/E ratio may suggest that the share may be too overpriced and the value of the share may fall in future to balance what the share may be worth and the market value of the same. While a share with a low P/E may signal a very attractive price for actually adding it to your portfolio and maximizing the gain when the share realizes its potential. Value investors always emphasize long-term investing in portfolios having higher future earnings potential after factoring in key indicators and they always consider the P/E ratio of shares that belong to similar industries.
Evaluation of P/E ratio:
The P/E ratio should never be viewed in isolation as it makes no sense. It should always be used in conjunction with shares or portfolios of similar sectors. An individual company in the energy sector that has a high P/E would not attract eyeballs if the P/E ratio of the entire energy sector is on a rise. Red flags should be raised when a particular share moves in the opposite direction of the portfolio constituting the industry from where it belongs.
A considerable amount of debt can have a negative impact on the share price as well as the earnings of a company. This might result in a lower P/E ratio than a company belonging to the same sector. But many a time, the capital in the form of debt can result in enhanced future value unlocking and earnings which may get lost due to short-sightedness.
It is extremely important to study a portfolio and its associated valuation from the lens of the P/E ratio although it might not be the only ratio which needs to be looked into. A company’s share price is available in the stock indexes but the earnings of a company might be inflated intentionally to dupe honest investors. The manipulation might lead to inaccurate P/E ratios thereby making the stock riskier and preventing investors from taking sound decisions.
A value investor would always look at the P/E ratio in relation to other financial indicators before making a bet in either a stock or an equity mutual fund scheme. The P/E ratio can be a double-edged sword. On one hand, if you value fundamentals and intrinsic drivers of a company which leads to revenue growth and cost competitiveness, the P/E ratio can be one of your best tools. The concept of a high or a low P/E ratio is dependent on the sector and the completion and fair analysis of what are the drivers which can lead to the maximization of portfolio valuation.