How to value a stock
Before making investments, one has to evaluate it. For valuating stocks, comes the investment valuation ratio which is the P/E ratio. As a value investor fundamental metrics will be the first priority to value a stock. For calculating P/E certain circumstances may be informative & in some cases it is quite difficult. P/E ratio plays a vital role in determining valuation of the securities. Therefore P/E helps to determine the stock is overvalued or under valued.
What is a P/E ratio
P/E or valuation ratio is calculated as
Market Value per Share / Earnings per Share (EPS)
Trailing P/E – P/E calculated with EPS of last four quarters
Leading or projected P/E – P/E calculated with analyst estimates of EPS of next four quarters
Generally in the market P/E ratio will waver in the range of 15 to 25 depends on economic conditions. Sectoral wise difference in P/E prevails.
How to use P/E ratio
P/E ratio not only speaks past performance but also tells the market expectations over the future. If a company has P/E higher than market or sectoral average ,it has to live up to the high rating by increasing its earnings or the price of the stock has to drop.
Along with the market price P/E ratio acts a good indicator to value a stock.There are two major factors involved in determining P/E.
Company’s growth in the past and how it maintains consistent performance in increasing the growth rates as per expectation. If a company’s growth rate doesn’t meet the projected P/E ,then the stock is valued as overprice. In this case P/E is taken according to projected EPS.
2.Sector or industry
It adds meaning only if companies in same sector are compared.Because multiples differs in accordance with industries. So one only compare high growth companies to others in the same industry or to the industry average.
Shortcomings of P/E Ratio
Some of the factors that drags down the usefulness of P/E ratio are
One of the accounting factor is Earnings which is based on Generally Accepted Accounting Priniciples(GAAP) . GAAP always changes on some decisions & also factors for calculating GAAP varies depends on the country.
During high inflation,inventory and depreciation were undervalued as goods & equipments replacement costs rise with the prices. As market moves upwards artificially ,P/E ratio will be lower at this instance. Considering inflation ,prediction using P/E results in vain.
Some misinterpretations of P/E : A low P/E not only mean that company is undervalued but it may also mean that company will be in trouble in near future.
The above chart clearly shows that one can buy stocks when P/E reaches 15-16 and not to proceed with buying if it crosses 22
One should not value stocks using only P/E. Even if P/E is high which doesn’t mean that it will come down anytime soon. If a stock is undervalued it could take years for the market to value it properly.