P/E is the ratio of profit after tax to the total number of shares outstanding. Another way of calculating it is to divide the share price by the EPS. Finding the share price is simple. Complexity starts with calculating earnings. It could be TTM (trailing 12-month earnings) of current/previous year or projected earnings for the forthcoming year.
The P/E ratio tells you the number of years at constant profits it will take to return the investment. So, a stock with a P/E of 30 means, if the profit remains the same, it will take 30 years for the investment amount to come back to the buyer.
One of the biggest challenges of earnings is that it does not take into account the capital structure of a company. In simple terms, it means it completely disregards the debt taken by a company.
The P/E ratio tends to capture the agony and ecstasy of the market. When the market is in the bear phase and investors are despondent about the future, P/E ratios of companies and indices will contract. Exactly the opposite happens during a bull phase.
Ben Graham used the P/E ratio to determine a “moderate upper limit to stay within the bounds of conservative valuation.” On the other hand, William O’Neill, the father of CANSLIM, said “Contrary to most investors’ beliefs, P/E ratios were not a relevant factor in price movement.”
In his detailed study of stocks between 1953 and 1988, O’Neill found that the average P/E before a stock made a major bull move was 20 as opposed to the average Dow P/E of 15. Even in the Indian market, anecdotal evidence supports the fact that there are some perpetually high P/E stocks like Asian Paints, Berger, Nestle, Page Industries, Symphony, Pidilite, D’Mart (Avenue Supermarts) and Titan.
PI ratio (P/E to Index)
Divide a company’s P/E with that of the index (Nifty) to calculate the PI (PE to index) ratio. For example, say Asian Paints has a P/E ratio of about 125 while Nifty P/E is about 37. That is, a ratio of 125/37 = 3.3 times.
In January 2006, the same ratio was 28/17 = 1.6. In January 2015, it was 60/21 = 3. If you do this exercise, you will find that Asian Paints usually trades between 1.5 – 3.5 times of PI (PE to Index) ratio. You can do a similar exercise for the stocks you are interested in and find the range.
The PI ratio tells you how much a stock is being valued by the market with respect to the overall market.
Never sell a stock on high valuations. It is always best to have a trailing stop (a stop loss that keeps trailing the price as the stock price moves upwards), because stocks can remain at a high P/E or can go to a higher P/E during a major bull phase, and selling out early often means you are not participating in the most explosive phase of price rise.
Again, if you followed this suggestion, you would be comfortably riding stocks like D’Mart even at 100-plus PE, earning the wrath of value investors. The only exception to this is if you are invested in a very illiquid stock, where you may need to start liquidating on the way up.
In short, use the P/E ratio as a general guide to understand how a stock or an index is being gauged by the market instead of using it as a valuation metric.