Price-Earning Ratio or PE ratio is the most popular ratio amongst stock market analysts and investors. How many of you feel that a stock with lower PE is a better pick over a stock with higher PE? Well, that is only partially true. In fact, in some cases, a stock with higher PE might be a better pick over a stock with lower PE. Let’s see where you are going wrong!
PE Ratio Varies Across Different Industries
Many amateur investors try to compare the valuation stocks of the different industries using the PE Ratio. That’s not the right approach. You cannot compare stock valuation of Britannia to the stock valuation of Bharti Airtel based on their PE Ratio. If you are doing it, it is a blunder!
PE Ratio = Price of Share / Earning per share
So, it means that how many times of EPS is the share priced currently. Since EPS represents corporate earnings so, this is a ratio which compares companies based on their corporate earnings. We cannot compare the corporate earnings of two different industries as every industry has different dynamics. Though we may compare whether company’s own performance has improved from the last time or how is the company doing in comparison to it’s peers in the same industry. Again taking the example of Britannia, it’s PE may be compared to the PE of Nestle as they belong to the same industry.
Higher PE due to premium
You may draw a wrong conclusion even if you compare two companies from same industry but the companies operate at a very different level in the market i.e. one company is very big with an excellent market reputation of its products all over India whereas the other company is a very small company relatively, which supplies only in a few states in India. In such case, the bigger company will have a higher PE almost always as it enjoys the market reputation premium. Therefore, we cannot say that since PE of the bigger company is higher in comparison to the smaller company, so bigger company’s stock is expensive in comparison to the other company.
A stock with lower PE is a better pick over a stock with higher PE only and only if you are comparing two companies from same industry and they operate at the same level in the market.
PE ratio is not this simple though. There are many other important aspects to considered, which we will cover in future articles. Stay tuned!
CA Sahil Goel | LinkedIn