While reviewing the valuations of the stocks the price/earnings ratio is one of the most frequently used tool. By valuation means, general assumption that the particular stock that have less P/E ratio in comparison to other stocks, in the specific sector/industry and market conditions is considered as an attractive buy opportunity and the stock with high P/E likely to be considered as risky and is better to offload from stocks portfolio.
P/E is calculated by Market value per share divided by Annual Earnings per share (EPS). So, P/E = Share Price/EPS. For example, the P/E ratio of company xyz with a share price of $20 and earnings per share of $4 is 5.
The value is the same whether the calculation is done for the whole company or on a per-share basis, above we have calculated the P/E on per share basis and for the whole company P/E can simply be calculated as a stock's market capitalization divided by its after-tax earnings over a 12-month period.
EPS is after-tax earnings over a 12-month period, usually the trailing period but occasionally the current or forward period divided by number of share.Theoretically, a stock's P/E depicts how much investors are willing to pay per dollar of earnings. For this reason it's also called the "multiple" of a stock or "earnings multiple". For example, a P/E ratio of 10 suggests that investors in the stock are willing to pay $10 for every $1 of earnings that the company generates. However, this is just a far too simplistic way of viewing the P/E because it fails to take into account the company's growth prospects.
The P/E is considered by many analysts and investors to pick value or bargain stocks. The underline assumption here is the concept that the companies that run similar businesses (i.e. from the same industry/sector) should have a similar P/E. Therefore, low P/E stocks are often considered as bargain or value pick. Now the question arise, Is it really a truth? .....the short answer is "Not always" let's review it below.
P/E and Financial Analysis - A contrary review!
Under some cases low P/E stocks could be cheap, but the cheap stock picks or value hunt is little tougher to find practically, due to their(stocks) low profile or absence of the much information sources available regarding them to highlight their potential and may be less discussed on media or analysts. When those value picks come into limelight, they already reached fair valuations and seems little late to enter or invest in them for the general investors.
Simply Otherwise, many of stocks have not such attractive investments alone on the basis of P/E. it means that the real price of the stock is not as cheap as it seems to be.
P/E analysis is only valid under certain assumptions or circumstances and it has its pitfalls. Some factors that can undermine the usefulness of the P/E ratio include:
Numerator Issues- Varying Market Capitalization. Let's understand this with example, consider a company with a low P/E ( Company P/E = Company's market capitalization/Annual Earnings after tax.) that has a large portion of debt in its balance sheet. In this case, the market cap of the company does not truly reflect its real value. The company’s real capitalization value or Enterprise Value (EV) would be the sum of its market cap and its debt (minus the company’s cash), making the numerator larger, thus the P/E will be larger than what it was initially calculated to be.
On the other hand, if a company has a higher P/E ratio, it doesn’t necessarily mean it is not cheap. If this company is loaded with cash, then again its market cap wouldn’t reflect its true value; in this case the EV of the company would be its market cap minus its cash, thus dramatically lowering the P/E value. In order to avoid this problematic feature of the P/E, it is wise to use a different ratio, called the Earning Yield (EY), which is calculated by dividing the earnings of the company by its EV.
Denominator Issues- Earnings after tax or EPS. As P/E is calculated as Market cap. divided by Earnings, the earnings has its dependence on the company’s past performance. The earnings of the past or trailing 12 months used here are not necessarily an accurate prediction of future earnings. A company could have a uniquely profitable or not so profitable year for many reasons but its future earnings could be obscure. Therefore, In other words, many stocks that are traded with high or low P/E has often deserve to have a low or high P/E respectively, because of their questionable future prospects on the basis of earnings.
Different Interpretations. Also low P/E ratio does not necessarily mean that a company's stock is undervalued. Rather, it could mean market believes that the company is headed for trouble in the near future. Stocks that go down usually do so for a reason. It may be that a company has lowered its future expectation figures or warned that earnings will come in lower than expected. This wouldn't be reflected in a trailing P/E ratio until earnings are actually released, during which time the company might seem undervalued.
In conclusion, its become really unfair analysis by valuing stocks using only simple indicators such as the P/E ratio. Although a high P/E ratio could mean that a stock is overvalued, there is no guarantee that it will come back down anytime soon. On the flip side, even if a stock is undervalued, it could take years for the market to value it in the proper way.
Other not so commonly used ratios, which can solve this lacking issue of P/E ratio regarding company's rate of growth, is the Price to Earning Growth (PEG) ratio (The PEG is calculated by dividing the P/E ratio by the company’s predicted annual growth rate). The PEG simply takes the annualized rate of growth out to the furthest estimate and compares this with the current stock price. Since it is future growth that makes a company valuable, the PEG ratio makes a lot of sense. But this is not the end of the story, since the PEG also has a crucial problematic feature – it depends on the assumed growth of the company, a parameter which is obviously unknown by itself.
Financial Analysis requires a great deal more than understanding a few ratios. While the P/E is one part of the puzzle. In any case, considering a low P/E as an initial screening tool or criterion for finding bargain stocks could be useful. However, this by itself does not assure a undervalue or cheap stock, and additional criteria s must be considered in order to explore a true potential stocks, like stocks with low Price/Book Value.
