In this video we will understand how the PE ratio affects the price of a stock!

But first, let us understand what PE ratio is.

In this video we will understand how the PE ratio affects the price of a stock!

But first, let us understand what PE ratio is.
PE ratio or the Price to Earnings ratio, is one of the most widely used accounting ratios by investors across the globe.
It reveals whether a stock is worth investing at its current price in terms of its earnings per share. In other words it can be expressed as the value you are paying for every 1 rupee in earnings.

PE ratio is calculated by dividing the current market price of a stock by the earnings per share.
So if a company has an earnings per share of Rs.50 and a current market price of Rs.1,000 per share then the PE Ratio would be
1000 divided by 50 which would mean a PE of 20.

But on a standalone basis it doesn’t give the complete picture. This is because PE of one company is not a representative of its standing in the industry and among its peers.
Ideally, investors compare the PE of a particular company to the average PE of the Industry that company belongs to.

So for instance, assume 2 companies are both trading at Rs.50 per share. They both belong in the same line of business. PE ratio can help an investor pick one of the two.
Company 1 reported an earnings per share of Rs.10, whereas company 2 reported an eps of Rs.20.
In this case, the PE of company 1 is 5 and that of company 2 is 2.5. This makes company 2 a more valuable stock to own.
But a lower PE ratio doesn’t always mean a better value proposition.

As on Q1 FY21, the average PE of the FMCG sector in India is around 60. While the average of the banking sector is around 25.
This doesn’t outright mean that banks are a more attractive valuation than FMCG.

This is because each industry has a different growth potential and they are valued based on their expected earnings.
An important thing to remember is that you should not value stocks solely based on the PE ratio. If a stock is available at a low PE doesn’t mean that the stock price cannot fall further.

Similarly a higher PE does not indicate that stock price cannot rise further.
As on Q1 FY21, stocks like Hindustan Unilever and Nestle are trading at a PE of 70. But they continue to make new highs too.
So as an investor, you should always do a more detailed analysis of a stock before arriving at a decision.

Thank you for watching.