Introduction
The stock market is a world full of technical jargons and really complex sounding words. It’s a nightmare for beginners. You read, see and hear confusing terminologies all over the media. It’s surprisingly difficult to find simple explanations of these complex concepts.
Here’s the thing about stock markets – you ask someone a simple question and you automatically get a complex answer to it. All you do after that is just nod your head to save yourself from looking dumb. The reality is, markets are intended to be kept “complex” so as to retain the value of those “experts” who already are in it.
The P/E Ratio
One such term that is thrown around at least a million times each day is the P/E ratio. Ask any question about a company’s stock and I can bet that out out 10 times you’ll hear the P/E ratio in the answer at least 7 times.
The P/E ratio is used so frequently that beginners usually find it too dumb to ask what it actually means. Googling the term gives you textbook definitions and formulae that seem daunting. But in reality it’s one of the most important concepts in the stock markets that one should understand thoroughly.
But like I always say, understanding a concept need not be just about learning the technical definition or knowing the formula to calculate it. It should instead be fun and easy to understand. So let’s break the P/E ratio down and try to understand it in simple words.
Your Business Venture
Assume that you and your best friend Mukesh decide to start a business. You register a company by the name “Best Friends Pvt. Ltd.” Each one of you contributes ₹50,000 towards the business as starting capital. In return, each one of you get 5000 shares at ₹10 per share. So now you own 50% of the business while Mukesh owns the other 50% of it.
Here’s the capital structure of your business:
- Company: Best Friends Pvt. Ltd.
- Total Capital: ₹1,00,000
- No. of Shares: 10,000
- Share Price: ₹10
- No. of Shareholders: 2
This share price is also known as the Face Value (FV) as it is the base rate at which the founders (you and Mukesh) have bought the initial shares.
A Successful Company
After a year of being in business your company has made good profits. After subtracting all the expenses and taxes, the company has made a net profit of ₹25,000. You are very excited as being 50% owner of the business you’re entitled to get half of the profit i.e. ₹12,500. That was a fairly simple calculation.
But what about the 5000 shares that you own? Well, those shares are what actually “entitle” you to receive 50% of the profit. Let’s see how.
Earnings Per Share (EPS)
Before we understand what a P/E ratio is we need to understand what an EPS is. Don’t worry it’s really simple. In fact, the name itself is self-explanatory. Earnings, per, share! “Earnings” is nothing but just another word for profit. So EPS tells you exactly how much profit each one of your 5000 shares is entitled to.
EPS = Earnings / No. of Shares
= 25,000 / 10,000
= ₹2.5
So out of the total profit that your company has made, you’ll get a profit of ₹2.5 per share. Now that you own 5000 shares, you’ll get ₹12,500 as profit (2.5 x 5000). Same applies to Mukesh and he’ll get his part of the profit i.e ₹12,500.
The Third Shareholder
You are really happy with the way things are working out at your company. Over a weekend, while you’re at a restaurant (splurging your profits), you meet your old friend named Shashank. You tell him how well your new business is going and how you expect it to grow further in the coming years. Shashank keenly listens to you and appreciates your work. After a good day, you both go home happily.
That night, Shashank thinks to himself – Wow! that’s a great business venture they both have started. Even I see potential for growth in their business. It would be great if I could own a part of their profits somehow.
But he knows for sure, that he won’t be able to buy shares of your company at the face value of ₹10 per share. Why? Well, because those shares were limited to you and Mukesh who initially took the risk of starting the business. After putting in all the hard work, now that your business has started to grow why would you want to sell your shares at the face value of ₹10 each right?
Shashank knows this very well but he also wants to have a piece of your company’s profits. So the next day, he meets you and makes you an offer to buy 1000 shares of your company at ₹15 per share. Notice that he has added a premium of ₹5 per share over the face value of your shares.
You discuss this offer with Mukesh and you both find it as a good deal. You both agree to sell 1000 shares (500 each) of your company to Shashank. It’s a win-win deal for all. You and Mukesh get a premium of ₹5 on your shares while Shashank gets an ownership in your company.
The Magic of P/E Ratio
In the above deal, Shashank valued your shares at ₹5 premium. But what does that mean to your company and to any potential future investors who might want to invest in it? Investors cannot just randomly keep on adding ₹5 premium on your shares just because Shashank did it. There has to be some defined valuation method to this. Well, this is exactly where the P/E ratio comes into picture.
P/E ratio stands for Price-to-Earnings ratio. This name is confusing. It’s actually not just price-to-earnings but instead it’s price-to-earnings-per-share or Price / EPS.
Let’s see at what P/E did Shashank value your company’s shares when he bought those at ₹15 per share.
P/E = Share Price / Earnings Per Share (EPS)
= 15 / 2.5
= 6
That means Shashank bought your shares at a P/E of 6. This in turn means he valued your shares at 6 times of your earnings and still found it worth to buy. For future investors, they now know that your company’s shares are valued at 6 times your earnings. For this reason, P/E is sometimes also referred to as the “multiplier” valuation method.
Essentially, Shashank has paid 6 times more than you and Mukesh just to earn every ₹1 of profit of your company. You paid ₹10 to earn ₹1 of profit share while Shashank has paid ₹15 to earn ₹1 of profit share.
Importance of P/E Ratio
A future investor who might buy your shares at say ₹20 per share will set the P/E ratio to 8 (20 / 2.5) and so on. Some investors might find it too expensive to buy your shares at a P/E of 8. Why so? Because they might find some other company similar to yours that might offer them their shares at a P/E of 5.
As you might have understood by now, P/E helps you to understand how cheap or how expensive the shares of a company are with respect to their earnings potential. There is no hard and fast rule as to what defines a P/E ratio as cheap or expensive.
It varies from industry to industry as each industry operates under different factors like profit margins, capital intensity, etc. Still, as a thumb rule a P/E between 8 to 12 is considered to be good for quality companies across most industries. You can also compare the P/E of a company to its industry P/E to get a fair idea of how cheap or expensive a stock is.
Also, a stock with an expensive P/E ratio does not necessarily mean that its not a good stock to buy. In fact, it’s expensive for a reason. More and more investors see growth potential in the company and so are ready to buy it at higher valuations. Same applies for a stock with cheap P/E. It’s cheap for a reason as not many investors are willing to buy the stock at higher valuations thereby indicating that not much growth potential is seen in the company.
In my observation, taking an investment decision based just on P/E is as good as flipping a coin and taking a decision. No doubt that P/E is an important factor but it’s pretty much useless on its own. You should always analyze a company as a whole and evaluate it’s other fundamental factors as well before deciding to make an investment in it.
As an exercise, you can just check the P/E ratios of your favorite stocks and compare them with their industry P/E. This way you can understand how cheap or expensive your favorite stocks are trading relative to their industry peers. You can easily find this information on any stock market portal like Moneycontrol.
For eg. as of today (08-May-20), RELIANCE is trading at ₹1561 per share. The P/E of this stock is at 32.04 while its industry P/E is 18.53. That means its significantly expensive to buy at this level but at the same time Reliance is a quality company so such high P/E is sometimes justified among the investors.
Now that you fully understand what a P/E ratio is and what it actually means, make sure to throw the term around when discussing about stock markets. Say something like “the P/E of that stock is not very attractive” and I bet you’ll impress the other person. If the other person is just a beginner, you’ll instantly become an “expert” for him / her 😉
I hope I was able to explain the details of this topic in a simple way. If you still have any queries or feedback, write to me at shashank@stocktalk.in
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