Once you have understood the advantages of investing in the stock market, you will want to begin your investing journey. Many would agree that the next logical step is to open a Demat account. However, once you open your Demat account and start exploring your trading app, you will encounter terms like derivatives and commodities. Open the price chart, and there are several indicators that you can apply. It can intimidate a new investor. However, as a new investor, you should not worry about what is a derivative and how to apply those indicators.
As a newbie, you need to start with the basics: learn to identify fundamentally strong stocks as potential investment options. To identify good stocks, you must have some basic knowledge of fundamental analysis. Fundamental analysis involves evaluating the company’s finances, business, competitors, and valuation. It may sound complicated, but there are several metrics and ratios to help you to analyse a stock’s fundamentals. The PE ratio is one of the most widely used ratios. So let us learn what is PE ratio, and how you can use it to pick out stocks.
What is PE Ratio?
The PE ratio or the price-to-earnings ratio indicates the relationship between the current price of the company’s shares against its earnings or net profits. In other words, it tells you how much money you have to invest in one share for 1 rupee of the company’s earnings. Looking at a stock’s PE ratio, an investor can evaluate whether the stock is overvalued, undervalued, or reasonably priced. To find a stock’s PE Ratio, simply divide the share’s current market price by its EPS (earnings per share).
However, today, you do not have to calculate the PE ratio manually. Your stock trading app or website should show you the PE ratio with a few clicks. By default, you will find the 12-month trailing PE ratio on a trading website or app. It considers the EPS of the last 12 months. The forward-looking PE ratio is another type of PE ratio where you estimate the future earnings and use those estimates to compute the stock’s PE ratio.
Why Should You Use The PE Ratio?
You, as an investor, want to invest in the stocks of good businesses to reap decent returns in the future. Those stocks consist of companies that have the potential to expand operations and generate strong earnings in the future. As the company’s profits increase, the company’s value will also increase. Investors expect such companies to do well in the future. When an investor comes across a business that can fulfil the previously mentioned criteria, the investor may invest in that company.
However, the stock market is always forward-looking. It would help if you always remembered that, like you, millions of other investors are anticipating exceptional earnings. In such a scenario, investors start buying that particular stock as they expect it to perform well in the future. In that process, they drive its current price to the roof. It often results in an event where the market values the stock to the extent that even its future earnings do not justify its price.
On the other hand, the downside in such stocks is very high. If the earnings numbers fall short, even by a margin, the stock price can collapse. You want to avoid such stocks and can do so by evaluating their PE ratio.
How to Pick Stocks Using PE Ratio?
If the PE ratio of the stock is high, the stock is likely trading at an overvalued price. So, does this mean that you go and invest your money in stocks that trade at a single-digit PE ratio? The answer is no. Generally, when the market does not foresee a strong earnings growth in a company, that company will trade at a low PE ratio. Another critical point to note is that the market assigns a stock a PE ratio based on the underlying nature of its business.
For example, stocks of FMCG companies generally trade at a PE ratio higher than 45. That is because there is almost consistent demand for the products of such companies, which results in consistent earnings. On the other hand, the steel manufacturing business is very cyclical, so steel stocks trade at a single-digit PE ratio. So, it would not make sense to compare the PE ratio of an FMCG company with a steel manufacturing company. It would be best if you compared the PE ratio of companies that are more or less in the same business. So, when most FMCG companies have a PE ratio between 45 to 60, avoid investing in the outlier that has a PE ratio over 100. The FMCG company with a PE ratio of 100 may potentially be the fastest-growing company of the bunch. However, its rate of growth is likely already factored in.
Now that you understand what is PE ratio, remember that it is just one metric to help evaluate a stock from a fundamental perspective. So, as an investor, you should consider other factors and metrics while picking out stocks. The PE ratio should not be your be-all and end-all for stock picking. Once you well-acquaint yourself with the fundamental concepts, you can then learn more advanced concepts like what is a derivative.