For an investor to invest should the PE ratio be high is the money question.
PE = Market price per share
Earning per share
PE ratio is derived by using the above formula and EPS could be derived using the formula expanded below.
Earnings per share = Earnings attributable to share holders
No: of Shares
Having a higher PE ratio is definitely is a strength of the company. Because it shows the confidence the investors has placed on the shares of the company.
lets take an example to further understand the anomaly of PE ratio.
company A has a PE ratio of 16, and the earnings per share is Rs. 5, company B has a PE ratio of 5 and the earnings per share is Rs. 5.
Based on the figures the market prices of the two shares can be derived as,
A = 16*5 = 80
B = 5*5 = 25
See an investor is paying Rs. 80 for a company which is making rs. 5 earnings per share, where as he could have invested in a company with similar earnings for an amount of Rs.25.
If an investor seeks speculation definitely he would opt for company A, because in a booming share market investors tend to invest on shares with high PE ratio. But in the long run put your money on the company with lower PE ratio. When the industry PE ratio is improving there is higher probability that the market price would improve.
"But in the long run put your money on the company with lower PE ratio. When the industry PE ratio is improving there is higher probability that the market price would improve."
ReplyDeleteCan you please explain this ? Because i have few doubts...........
There are two types of investors.
ReplyDelete1) Value Investors
2) Growth Investors
Value investors analyzes companies with low share prices but with high potential. And Growth investors invests in growing stocks. In the long run the value investor creates more income since the stock was under priced and thus with realization of the potential the value investor can make a lot of money. PE is the main indicator that value investors look at. Value investors compare the industrial PE value and the company's PE value.
A share with a Low PE value means that you are paying less to purchase a share which is earning more. Thus with value realization the you could benefit.
Hope this explains Nishan.
Yes , Sajith you have explained it well.
ReplyDeleteBut sometimes in the market, it's not true that the value investors always create more income in long run .
Because some investors don't justify the PE of the company before they invest.
Some companies have lower P/E ratio because of the low rating of earning growth.
If you blindly invest in a that kind of stock by comparing the industrial P/E and company P/E without justifying it's P/E, your stock P/E may not be able to reach to the industrial P/E .