Why you shouldn’t depend only on PE ratio?

As we saw last time, PE ratio is one of the most popular ratios used in determining the value of the stock. However despite its claims of helping you choose the bargain stocks, this ratio does have its own share of drawbacks. Here are the drawbacks of PE ratio

• PE ratio varies from sector to sector. A PE ratio that is considered high in one sector may be treated as low in another sector. E.g. IT companies usually have higher PE ratios than manufacturing companies. This is because IT companies are expected to show more growth over the period of time than manufacturing companies.
• PE ratio is not totally neutral. If the company declares it has received a new order or bagged a new client, is enough to send the PE ratio soaring.
• Also low PE may mean the lack of investor confidence in the company. It can imply serious problems with the company. So always find out more about the company’s background.
• One of the factors used in calculating EPS is assumed. It is based on the expectation of the company’s future performance. But this can be a problem as the company may not be able to continue with its good performance in future. Moreover the business in which the company is operating can experience problems. This happened recently in the real estate sector.

So when selecting the stock, don’t just take a look at the PE ratio. You also need to look at various other ratios and aspects. We will cover it in next posts.

The Mantra to Stock Market Success

What makes investors like Warren Buffet and Benjamin Graham successful in the stock market? Why is it that some people make money in stocks while others don’t? The answer – they follow the simple mantra of investing: buy low, sell high.

Though this mantra is popular amongst stock market investors, the question is how do you define low. What is low? How do you know that the stock price is at the lowest?

To understand that, check if the market price of the stock is lesser than its value. This is because market price is the price the market is ready to pay for the company’s share. The value is the price of the company’s business. Unlike the price of the stock which fluctuates from moment to moment, the value of the company’s business is stable, as the nature of the company’s business doesn’t change very quickly.

When we say buy low, we mean buy the stock when its price is lower than the value. This lets you get quality businesses at bargain prices.

E.g. if the value of the company’s business is Rs 200 and its price is Rs 130, the stock is said to be available cheaply.

It is called as “margin of safety” principle, advocated by Warren Buffet and Benjamin Graham.

In the next part, we’ll see how to calculate the value of the company.

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