Today number of investment options are available in the market to invest in. But, the worry is where to invest so that you can earn maximum return. Stock market has always been the central attraction for all who want to earn some extra income/profit. However, one needs to learn stock market to give their investments a safe and secure landing. Merely knowing some high dividend yield stocks is not sufficient. You need to understand the business of the company, future prospects, intrinsic value of share and the ROI i.e. the returns on the investments.
No matter you trade individually or through a broker, it’s always better to have clear understanding about the company while investing. It has been observed that the decisions of management can alone affect the sentiments of the investors that in turn affect the price of the stock. So it is really important to know that the market price of the stock reflects its fair price and is worth investing i.e. whether it is overpriced or underpriced. Among the many decisive factors that play a key role in selecting the stock for investing, one of them is P/E i.e. Price Earnings Ratio.
You can easily calculate this ratio if you have the annual balance sheet of the company. All you need to do is take the equity share’s current market price and divide it with the EPS i.e. Earnings per share of the company. EPS if not explicitly mentioned in the Balance Sheet can be found by dividing the total earnings i.e. net profit by the total number of shares. Now, what does this ratio exactly indicate?
If you analyze this ratio, then stock investments really seem to be relatively an easy decision making process. But first let us understand how to interpret this ratio. First thing to keep in mind – The higher the ratio, the better the company is. However, this is also subject to the market capitalization of the company. That is considering companies with almost same structure are important. At times, it may happen that the P/E of a small company is more than that of an MNC. This is because of the number of stocks being traded. Second thing is – The rate of growth of the EPS. A better growth rate implies that you can breakeven your investments earlier. So, a better P/E ratio implies that a company is expecting its earnings to grow at a faster rate.
When it is about stocks and investments, P/E comes as a handy tool to compare between multiple investment options. There is another concept of Forward P/E multiple, which is calculated based on the future value of EPS. This gives you a better insight about the P/E down the line after say n years of investments. You can definitely know better where to invest if you are equipped with the company’s P/E ratio based on the returns and earnings you get.
About the Author
Rajat Sharma is a well known stock market analyst and commentator. He has covered Indian markets for over a decade and is regarded for consistently identifying early stage investment opportunities. Attorney by qualification, Rajat has done extensive work for improving corporate governance and disclosure standards.Follow @SanaSecurities