What is the role of 'Price to Earnings' in Stock Market Investing?

Price to earnings is the number of times a stock is trading of its yearly EPS (earnings per share). Suppose, at a given point in time a companý’s stock is trading at a price of INR 60 (Rs.60) and its yearly EPS at that time is INR 6. Then it means its price to earnings (PE) is 10 as the stock is trading 10 times of its yearly EPS (10 * 6 = 60).

Just search any company's name in the above search box on our site and you will be able to find all the financial data of past 10 years of that company including the company’s latest stock PE (price to earnings).

Price to earnings is an important indicator that indicates how cheap or expensive the stock is available for buying on the open market. In other words, it tells about the valuations of a company's stock. In other words, it tells whether the stock is undervalued or overvalued.

Usually, any company stock that is trading at a PE multiple of less than 10 is considered undervalued and it is worth buying (unless there is a huge debt on the company). Stocks trading at a PE multiple of 30 and above are usually considered expensive (overvalued) and there is risk involved while investing in such stocks as they are trading at expensive valuations (as PE is high). This is so because in bear market PE of even many good stocks may shrink below 10 or 20 and may jump above 20 or 30 in the bull market.

If you have bought a particular stock at an expensive valuations (at higher PE multiples) during the bull market and if suddenly the bear market comes in then it may take longer time to reap the benefits of your investments as surely the price of the stock will go down in a bear market because in general stocks trade at lower PE multiples in a bear market without any reason. The fear factor dominates in the bear market and usually, people don’t buy at that time.

Also, many people who have bought during the bull market are now stuck with the losses in the bear market and they either tend to sell (due to fear of losing more money) or don’t buy anymore.

That is the reason that price to earnings (PE) of a stock helps a lot in deciding whether the stock is worth investing or not at the time you want to buy.

Personally, I always wait for a bear market to buy my stocks when even best of the company stocks are trading at much lower valuations. I generally buy when PE is less than 10 or at least 15 if the business model of the company is extremely good. It’s during the bull market (when everyone is optimistic) I always sell and run away from the stocks and that really works for me as I know from my experience that at the end of every bull market there is a horrible bear market and it appears suddenly.

A look at the historical charts of Indian Sensex and Nifty will exactly tell you that. You can always find dips in prices after steep rises at regular intervals on 20 years old historical charts.

But PE is not only the factor to consider while buying a stock. You should also look for debt to equity and return on equity.

Another great way the concept of PE can be utilized when quarterly results of various stock listed companies are declared four times in a year. As mentioned here in more details many of the Indian companies declare good quarterly results, with a significant increase in their quarterly EPS, but still, the prices of their stocks don’t appreciate at all (or appreciate slightly) as sometimes these undervalued company stocks don’t get noticed by the investors and the traders alike.

When EPS rises and price of the stock don’t appreciate then PE becomes low and as a result, the stock becomes undervalued. You need to find and buy such stocks before everyone else does and that is surely going to make money in the future as the market participants will eventually increase the price of such undervalued stocks by buying them. Just you need to buy before they do in order to make good money. This is another good way to make money from stock investing other than buying stocks in the bear market as mentioned earlier in this article.

Written By: Rajesh Bihani, senior writer at sharemarkethow.com

Disclaimer: All the information compiled and presented here on this site is based on our financial background knowledge, years of practical experience, and recent research. But still we are not legally authorized to recommend stocks and so the information should be taken as our personal views only.