is PE Ratio still valid?

We heard very often about the P/E ratio. This ratio is used to measure stock”s valuation. However fifty years back which ratio was used  by Equity analysts. Today, a lot of things have changed dramatically.. Typically, this ratio could measure whether the stock is undervalued or overvalued. First we need to start from the basics.

 

What is P/E Ratio?

Price earning ratio is full form of P/E ratio. P stands for Market price (securities closed at last trading session). E stands for Earning per share (earnings of per unit of share).

For Example, if company market price at Rs. 300 its EPS is 30 that means P/E ratio will be 10 

Market price / Earning per share = P/E ratio. 

Two types of PE ratio

This Ratio divides as two categories those are, Trailing P/E and Forward P/E. 

The trailing PE is the last four quarters earnings average which is taken as the full financial year P/E. the value investors who observe trailing PE because it is more authentic generally investigate past 5 to 10 years track records. If stock trades below historic average that is considered as an undervalued stock. 

The growth investors who look at forward PE Ratio  this is why, who would make investment decisions based upon future growth. Forward projection is made by some statistical calculation that has a high probability to either go right or wrong.  If forward PE is higher than current PE which means the stock could earn less than now. On the other hand, if it is lower than current PE, the investors might consider that stock earnings will be higher than current eanings. 

High PE VS Low PE

Some stocks are trading with high PE but some stocks trade with Low PE. Why does this occur? The stock market participants are willing to pay a high premium for rapid growth stock. Normally, Non cyclical stocks PE will be high such like those stocks having strong brand name reputation, and deal with advanced technology. Unlikely affected by the economic downturn.

High PE stock includes  of high risk suppose it misses the street expectation the stock market will hit mercilessly. 

The cyclical stocks would perform better during economic peak time as well as do underperform during economic slowdown due to declining consumer”s product demand. Big ticket item such as Home and Cars sales will fall when interest rate hikes. 

Sector PE Ratio

The broader market has named Nifty and Sensex. Likewise, each industry group is indexed separately that is called Sector index. Which helps to identify its value and performance in the overall market. If a sector PE is below than broader market PE that considers which sector is trading in undervalue and controversially which sector trades in high PE than broader market PE that considers as overvalue. 

The short-term traders prefer High PE sectors but the condition is that High PE sectors' stocks has been providing better return than other sectors thus, they would like to catch that momentum. Low PE  sectors not likely to participate in broader market rally. 

The value investors would prefer Low PE sectors because those stocks might lift up in the market cycle. In their perspective, the overvalued high PE sector might pull down by market cycle. For example, in 2018, Information Technology index PE was 18 while Nity PE traded at 26, although, IT index has done astounding movements for a  couple of years. Metal Index also did the same performance like IT.

The broader market PE ratio

The PE ratio is not stand alone criteria to evaluate stock valuation because Low PE stocks might hurt by High debt, Low growth, less operating margin or face net loss. PE ratio is not essential to measure individual stock and sectors. But these definition will not be match with broadr market. Let look below the chart.

          

The Nifty”s historical average is 19.5, as an stock market analysts view, nifty PE if goes below 14 that is considered as oversold zone as well as it moves above 22 PE that is considered to be an overvalue zone. In september 2021, Nifty PE reached at historical high of 42 which previous high occurred in 1996 while Nifty PE was 36. Whenever nifty PE went below 15 thus, investors got a huge return from their investment. During 2009 Nifty PE touched at 9, and 17 PE at Covid outbreak in 2020. Therefore, Nifty  PE ratio is a good indicator for investors who can identify whether the market is in Overvalue or Undervalue. when it comes to Individual stock or sector investors must look at other important ratios to weigh on those valuation. 

Equity Debt ratio, Return on Equity, Return on capital employed, free cash flow, and other qualitative measurement so on.

 

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