How To Use P/E Ratio To Take Investment Decisions?

P/E Ratio helps you find companies with ‘growth’ potential.

What comprises high or low P/E ratio? 

P/E ratio is a relative measure i.e the P/E ratio of a firm is always considered in relation to the P/E ratio of another firm (preferably belonging to the same industry).Therefore, there is no cut-off score that determines whether the P/E score of a company is high or low.

Thus if Company Q is currently trading at a P/E ratio of 8 and a comparable company (say Y) in terms of business, size and profitability is trading at a P/E ratio of 15, we can say that Company Q has a low P/E score.

It however does not mean that Company Y is better or worse than Company Q. 

However, it certainly means that Q is currently available at a cheaper valuation than Company X. 

>> What does P/E ratio signify?

P/E ratio signifies to a large extent the kind of confidence the investors have in the ‘future growth’ prospects of the company. 

If a company is trading at multiple times its current EPS; it signifies that the investors are confident that the future earnings of the company would grow over time.

>> How to use the P/E ratio to take investment decisions?

P/E ratio can an important consideration when finding ‘value’ bets to invest in. We compare the P/E ratio of a firm with industry peers as well as with the industry average to arrive at buy or sell decisions. 

In other words, P/E Ratio tells you whether a stock is under or over valued.

Continuing with the example I used above, Lets say that you want to choose between company Q and company Y to invest in. These are two comparable companies operating in the Pharmaceutical Sector.  The average P/E for the Pharma Industry is 12. 

Company Q with a P/E ratio of 8 is currently trading a valuation which is cheaper than both its comparable peer (company Y – trading at a P/E of 15) and the industry average P/E of 12. Thus, other things being equal, Company Q provides a better investment opportunity than company Y – given its cheaper valuation. 

Fundamentally sound and profitable companies with a low P/E score can present good buying opportunities for the long term. This is because their growth potential is yet to be discovered by market participants. When their growth potential is finally discovered – leading to some frenzied buying, the market price of the stocks would move skywards.