PE ratio – Demystified!!!???

Price to Earnings ratio is an important ratio that almost all investors in share market will track. It is an easy way to value a stock. But is this ratio so easy that one can take it from the print ad for results given by the company? Nopen it's not. It’s far tougher and complicated. In fact PE ratio can’t be considered in isolation for one company alone. In this section, I will try to analyze all the different aspects of PE ratio.

For starters PE ratio is nothing but the ratio of market price of a stock to its EPS (earnings per share). EPS is profit after tax of the company divided by the total number of outstanding shares. In simple terms what this ratio refers to is the number of years in which the company can earn the investor’s invested money (if the company continues to maintain its performance). For example if a company’s PE is 5, then it means that in 5 years the investor earns his money back (but doesn’t get it back). Now let us get into the complicated part:

The three different types of PE ratios that one can come across in many newspapers,

· Normal PE : It is the PE ratio that takes into account PAT at the end of a financial year. The problem with this ratio is that even after 9 or 10 months into a new financial year, one will be using data that is pretty old. Instead of this, one can use the quarterly results to find the current PE.

· Trailing PE : This ratio takes into account the PAT of the company for the previous four quarters. This ratio might give you the current status of a company, but it won’t be useful when you want to study the company over a period of time. Also if it is a seasonal business then the interpretation of this ratio might lead to incorrect decisions.

· Forward PE : This ratio takes into account the estimated PAT for the next financial year. This estimation is usually done by analysts who might not be correct. To avoid this pitfall usually what one can do is to take an average of all the analyst estimation and give an average PAT. However no one can estimate the future with confidence and with happenings in the recent economy, investor’s confidence in these analysts has deteriorated. When a company’s estimation of their own future earnings goes wrong, why should anyone care about these estimations?

Now there are three ratios, each one with their own advantages and disadvantages. What one can do is, keep track of all the above ratios for a perfect analysis of any stock. But care should be taken about the inferences that can be inferred from each ratio. Otherwise one might end up choosing the wrong stock for investing, which can be easily avoided using simple rules for screening stocks using above ratios.

The EPS we saw till now takes into account the number of outstanding shares. There is one more terminology called diluted EPS, which uses the total number of shares that can be outstanding. That is outstanding shares along with convertible bonds and stock options. This will give a more conservative EPS estimate because it takes into account future dilution of the company. An investor should always have an eye on this because there might be companies which has issued so many convertible issues or stock options that its diluted EPS tends to be lot less than EPS. So Diluted PE should is also important to pick stocks for long term.

To be Contd....