How PE ratio helps to buy best stock in the stock market?

P/E ratio is every beginner Investor’s measurement metrics to know the valuation of a stock. P/E ratio is nothing but the ratio of the price of a stock by its earnings. Let us understand how PE ratio helps to buy best stock in the stock market. In a more technical way,

P/E ratio = Market Price of the stock / Earnings Per Share

P/E ratio can give you a fair value whether the price of a stock is underpriced or overpriced. However, the valuation of a stock cannot be so easily determined by simply knowing the MP and EPS. The correct value of EPS of a share at current market rate is difficult to determine until a company discloses its quarterly reports of profits and in many case the company might not actually reveal the profit earned for the quarter. So, an Investor may be disillusioned by the P/E ratio. Thus, you should consider other parameters too when evaluating the price of a share.

Nevertheless, P/E ratio is not that uncertain and does give you a rough estimate of a stock’s pricing status.

How PE ratio helps to buy best stock and how is it measured?

A high P/E ratio indicates a growth stock. A growth stock usually has a P/E ratio of 20-30 or even more. If P/E ratio increases beyond 30, the stock is overpriced and has reached a level of its growth prospect. This does not compulsorily mean that all stock having high P/E ratio are overly priced; there may be exceptions but this is the general rule which is followed in the market.

A low P/E ratio indicates that the price of the stock has not risen much beyond its future expectations and there are still chances for the stock to grow even more. Such stocks are generally underpriced and this is where the Investors keep their eye on. Generally, stocks having a P/E ratio in the range 9-17 are considered worth buying. Do not go for too low P/E ratio since the lower value could be because of some flaw in the company’s fundamental like bad strategies followed, high debt, etc. The gist is to go for company stocks whose P/E ratio is optimum.

One more factor to be considered here is that we should not compare stocks from different domains by their P/E ratio. The reason is that IT and Telecom have high P/E ratio for almost all their stocks as compared to manufacturing, oil or textile sector.

An illustration:

Let us take the example of JB Chemicals. Suppose the market price for JP Chemicals is 246 INR and its EPS is 9.42. Then, by the formula, its P/E ratio will be 246/9.42 which comes to around 26.11 which means it is a high growing stock. You can give a thought for buying it.

JB Chemicals is from the Pharmaceutical sector. Let us now take another stock from the same sector, Aurobindo Pharma. Suppose the market price for Aurobindo Pharma is 870 INR and its EPS is 48.78. Then, by the formula, its P/E ratio will be 870/48.78 which comes to around 17.84 which indicates that there is more future growth to this stock than JB Chemicals and you can consider buying it. Thus, this stock will be a better bargain than JB Chemicals.

Now, consider the share price of RIL which is around 1033 INR. Its EPS is 68.89. Then, by the formula, its P/E ratio will be 1033/68.89 which comes to around 14.99 which means that there is more future growth to this stock and you can consider buying it. But you should not compare its ratio with JB Chemicals or Aurobindo Pharma to consider your buying decisions.

Caution: This is just an illustration to show how P/E ratio can be used for knowing the pricing of the stock. Your stock market decisions are at your own risk and this website does not hold any responsibility for that.

Things to Note: Take Aways

1. High P/E ratio indicates growth stock in the range 20-30.

2. P/E ratio of 30 are considered overly priced stocks. (The basic and initial Rule of thumb as coined by Benjamin Graham says that PE above 15 represents overvalued stocks, but this was determined decades ago and we must change the value of the ratio as per the current trend).

3. An optimum range of 9-17 as P/E ratio is best for buying future growth stocks.

4. Compare P/E ratio of stock within the same sector to know their status. P/E ratio is not a good measurement for comparing stocks of different sectors.

5. Do not buy stocks that have no P/E ratio or negative P/E ratio. Such stocks are losing money and not a good bet unless they make some drastic damage control.

6. Investors consider Forward P/E as one of the parameter these days. It is nothing but the ratio ofI the current market price divided by the expected EPS for the next 12 months (usually). This is calculated to know the future prospects of a stock.