PE ratio, perhaps the single most used, and abused, metric in the stock market, is a simple one. And perhaps that is why it has such widespread use. People use it as a shortcut for valuing companies. So, a company with a PE of 10 becomes cheap and one with a PE of 50 becomes expensive.
PE ratio is the ratio of profit after tax to the total number of shares outstanding. Another way of calculating it is the share price divided by the EPS. The share price is simple. The complexity starts with the earnings. It could be TTM (trailing twelve month earnings), current / previous year or the upcoming year (future).
The PE ratio tells us the number of years at constant profits it will take to return the investment. So, a stock with a PE of 30 means, if the profit remains the same, it will take 30 years for the investment amount to come back to the buyer.
One of the biggest challenges of earnings is that it does not look at the capital structure of a company. In simple terms, it means **it completely disregards the debt taken by a company.**
PE ratio tends to capture the “agony and ecstasy” of the market. When the market is in a bear phase and investors are despondent about the future, the PE ratios of companies and indices will contract. Exactly the opposite happens during a bull phase.
Ben Graham used PE ratio to determine a “*moderate upper limit to stay within the bounds of conservative valuation*”. On the other hand, William O’Neill, the father of CANSLIM, said “contrary to most investors’ beliefs. PE ratios were not a relevant factor in price movement”. In his detailed study of stocks between 1953 to 1988, O’Neill found that the average PE before a stock made a major bull move, had a PE of 20 as opposed to the average Dow PE of 15. Even in the Indian markets, I have seen enough anecdotal evidence to support the fact that there are some perpetual high PE stocks – Asian Paints, Berger, Nestle, Page Industries, Symphony, Pidilite, Dmart, Titan and many many more come to mind.
Use the PI ratio (PE to Index)
The way I use PE is to divide a company’s PE with that of the index (Nifty). For example, Asian Paints has a PE ratio of about 125 as I write this. The Nifty PE is about 37. That is, a ratio of 125 / 37 = 3.3 times. In January 2006, the same ratio was 28 / 17 = 1.6. In Jan 2015, it was 60 / 21 = 3. If I do this exercise, I find that Asian Paints usually trades between 1.5 – 3.5 times of my PI (PE to Index) ratio. You can do a similar exercise for the stocks you are interested in and find the range.
The PI ratio tells me how much a stock is being “valued” by the market with respect to the general market.
Never sell on valuations
Another practical experience that I have had is to never sell a stock on high valuations. It is always best to have a trailing stop (a stop loss that keeps trailing the price as the stock price moves upwards), because, stocks can remain at a high PE or can go to a higher PE during a major bull phase and selling out early often means I am not participating in the most explosive of price rise phase. Again, if you followed this suggestion, you would be comfortably riding stocks like Dmart even at 100+ PE and earning the wrath of closet value investors!!! The only exception to this is if you are invested in a very illiquid stock, where you may need to start liquidating on the way up.