Understanding P/E Ratio:
P/E ratio is a part of valuation ratios (ratios that are used to compare the share price of different companies or determine the current valuation of the company).
P/E ratio is part of the Price Multiples group also known as Equity Multiples or Trading Multiples under the Relative Valuation Technique of Valuation. Equity Multiples compare the price or market cap to Sales, Earning, or any other earning value. The other multiples being P/BVPS, P/Sales, and P/CFO.
The P/E ratio shows a comparison between the current market price and the earning of the company.
P/E = Current Market price / Earnings per Share or,
= Market Capitalization (CMP * No Of outstanding Shares) / Net Profit
Let’s understand how to read a P/E Ratio for the company:
- As of 3 rd July 20 closing, the P/E Ratio of Reliance Industries is 39.11 (Source: bseindia.com), which means that the price of Reliance Industries is 39.11 times the earning of the company.
- Similarly, on the same date, the P/E ratio of Bajaj Auto is 16.66, which means that the price of Bajaj auto is 16.66 times that of the earnings.
If the company is bought entirely, then the P/E ratio can also be defined as the no of years to get the Initial Investment back, keeping the earnings constant.
Investment Yield for Initial Year using P/E Ratio:
The initial yield of a stock is the return or yield to investment in the first year. It is given by the
Initial Yield = Earning Per Share / Share Price
Initial Yield is Inverse of P/E Ratio
Now, let us understand with one numeric example.
Q. Calculate the Initial yield for Reliance, using the above data and CMP as on 3 rd July 20 closing?
Solution: P/E Ratio = 39.11
Initial Yield = 1/ 39.11
Reliance initial yield on the given data is 2.19%, with a P/E ratio of 39.11.
In general, without reference to any company, a P/E ratio within a single digit is
considered attractive and a P/E ratio above 20 is considered expensive
Factors Affecting The P/E Ratio:-
Market Capitalization: High Market share usually has a positive impact on the valuation, as it is regarded as a strong factor for stable and high earnings, which in turn leads to high share price (Numerator in the Ratio).
Financial Stability: Plays a major role in the Liquidity and solvency position of the company. High debt companies are less financially stable and while making a comparison, low debt companies are preferred more. Till the time company can play on leverage, high debt can be used as a tax optimization tool, leading to high P/E in the long run.
Cash Flow Position & One Off Items: Companies that have higher cash flows and a large part of the same getting reinvested o=in business leads to a better P/E ratio. High growth companies normally have high Capex and tend to depend on external capital in spite of the high growth rate.
Company Management: Management is the “Brain behind the company”. They are the people responsible for driving company policies and growth. Different business models have a different degree of impact on the company. The exit of a key employee can have a serious impact on the Business and the P/E Ratio.
Analyzing the descriptive statistics for the data, we can find that the median P/E ratio for the period is 19.76, with the highest value recorded at 26.44. The chart shows that 73.9% of values lie between the frequency of 18 – 21 and 93% of values are less than the P/E ratio of 24.
This article is part of the FATP(Financial Analyst Training Program) and FMEV(Financial Modeling and Equity Valuation) program at RVM Finishing School of Finance. If you want to discuss career options or about your profile mail us at firstname.lastname@example.org or visit www.rvmfinishingschool.com
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