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.
As we saw last time, P/E ratio plays a vital role in valuation of a stock. It indicates the margin of safety of the stock. It tells you about the relationship between the stock price and the earnings of the company.
Let us say you buy a share of company A that gives you a return of 9% in one year. Here the margin of safety is zero as a traditional bank account also offers you the same return, but without any risk.
So in order to lower the risk, the difference between both of them must be higher. The renowned investor Warren Buffett advises us this difference must be at least 1.25 – 1.5%.
But be warned: when the markets are on fire, each and every stock gets high price. Hence it makes the task of detecting stocks having higher margin of safety quite difficult. But during the bear run, it can throw up the plethora of opportunities for long term investors.
In the next part, we take a look at the drawbacks of this ratio.
In the last article, we saw that in order to earn profit in stock markets, the price at which you buy the share should not exceed its value. So it is very important you calculate the value of the share.
Calculating the value of the share: First you must begin by reading through financial statements of the company. Acquaint yourself with the finer nuances of the stocks.
Then you need to understand the valuation methods of the share. There are 2 methods to do that.
First Method: Calculate the net liquid assets per share. It is done by subtracting the liabilities from the current assets and dividing the result by number of shares.
Net liquid assets per share = Current assets –liabilities / number of shares
Current assets include cash, debtors, liquid investments etc
The great investor Warren Buffet recommends paying not over 2/3 this figure for a share.
Second Method: Consider the PE (Price to earnings) ratio. It is calculated by dividing the market price of the share by Earnings per share (EPS).
PE ratio = Market price of a share/ Earnings per share
If the PE ratio is 1, you can say the share has fair valuation. If it below 1, it is undervalued and if it exceeds 1, it is overvalued.
In the next part, we’ll take a closer look at PE ratio.
Related Link: The Mantra to Stock Market Success