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Understanding Price – Earning (PE)
Finance - Fundamental Analysis

Earning (P/E) is one of the most widely term used in the share market. Every investor now a day supposed to know the term P/E. If the term is so important then what exactly it mean? The meaning of the term is in its name itself. It is ratio of Price to its Earning. In other words, it is the equilibrium of what market expects and how company has performed? Confused?



What is price of the stock? How the price of the stock is determined?



1) Stock Price: It is just the demand-supply concept. Price of any stock is determined on the basis of demand of that script and its supply in the market so in short it can be considered as the expectations of the investor from the script.



2) Earnings : Earnings mean earnings after depreciation and tax. In calculating P/E, earnings are considered per share to bring uniformity in calculation.



So EPS is the actual performance of the company, which is calculated as follows-



EPS = Profit after Tax( Profit for Shareholders) Number of shares outstanding.



Since P/E is the ratio of expectation and performance, it is calculated as –



P/E = Price of the share in the open market Earnings per share.



The next thing is why P/E is so much important while taking any investment decision? The answer to the question can be figured out from following-P/E is expressed in terms of multiple of EPS like 20x means price of the share is 20 time of its EPS. It tells you the time required to get your investment back in the form of return from company i.e. how much years an investor requires to wait for getting his investment back in form of EPS. (However while framing the judgment one assumption is kept in mind and is that the EPS will remain constant throughout the period.). The assumption seems to be unrealistic; as everyone knows that EPS can’t be the same. So for removing the defect one can consider the past profit trend and accordingly adjust the EPS and can make the formula somewhat realistic.




From P/E one can figure out about the expectations of the market from the particular stock. Higher the P/E more bullish is the market on the stock. In the current days most appropriate example is that of real estate stocks. Consider example of Lanco infratech Ltd having P/E 544. Means investors are highly bullish on the same, but one should be cautious enough while investing because market expectations always may not be correct. P/E expresses the market expectations from the company, however it does not means that the stocks with lower P/E are bad. On the contrary the stocks with lower P/E but good fundamentals can prove to be the best investment opportunity.



Thus it can be a useful tool for locating the gem in a coalmine. P/E is a useful tool for comparing two stocks belonging to the same industry or for comparing a particular stock with the industry. This comparison will direct the investor about the risk he will bear if opted for investment. For the long-term investment P/E will prove to be the effective tool.



There is one concept call PEG i.e. price to earnings growth concept. According to this, along with price the other important factor is that of the growth rate of the company.



Suppose the P/E of the company is 40 and the company’s growth rate is more than its P/E lets say 45 then it indicates that the stock of the company is undervalued and it is the best time to invest in the stock. The other use of P/E is to calculate future expected price of the stock –From the past trend expected EPS growth can be predicted so once expected EPS is finalized, calculating the expected price is a matter of minute.



Check the following illustration –Suppose Price of Infosys is Rs.2200,EPS is Rs.45Then P/E would be 2200/45 = 48.89Now Infosys has an average growth rate of 33% hence expected EPS will be around Rs.60 and expected price would be Rs.2933 (i.e. P/E multiplied by expected EPS)

 
 

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