Back to Basics . Things to keep in mind before investing in high P/E stocks

Investors use a range of financial ratios to help them assess the strength of a company and its stock, including the P/E ratio, P/B ratio and D/E.

Each of these ratios highlights a specific financial aspect of the company, allowing investors to make an informed decision regarding buying the stock.

Of these, the price- to-earnings (P/E) ratio is one of the most commonly used.

The P/E is the ratio of a company’s share price to its earnings per share (EPS = Overall earnings of the company/Total number of outstanding shares).

This ratio helps investors understand if the market value of the share is in sync with the company’s earnings. Let’s say a company has 10 lakh outstanding shares having a market price of ₹100 per share. Also, it has a total earnings of ₹1 crore. Therefore, EPS = 1,00,00,000/10,00,000 = 10; so, P/E Ratio = 100/10 = 10.

This means that in the market, investors are willing to pay ₹10 to get a ₹1 share in the company’s earnings.

What drives P/E

For a share in the company’s profits of ₹1, why would an investor be willing to pay ₹10?

This usually happens when investors believe that the company will generate high levels of earnings in the future. The share price usually outpaces a company’s earnings if the market expects it to grow fast.

There are many factors that drive P/E ratios. The primary factor is earnings growth since investors prefer companies with a sustainable growth trajectory.

Next, investors prefer companies with an ability to convert sales growth into profits. Also, investors look for companies with high return on equity capital and low debts. Finally, external conditions including social, economic and political also impact the P/E ratio of a stock.

P/E ratios can vary based on the sector/industry or the overall market conditions. The P/E ratio of a company should be compared with that of its peers to ascertain if it falls in the high or low category.

For example, in the paper industry, the average P/E ratio of companies is around 7 to 8. Hence, a company with a P/E ratio of 10 will be considered high.

On the other hand, the average P/E ratio of the FMCG sector is 30-50. Therefore, a firm with a P/E ratio of 10 will be considered low.

Look before you leap

While investing in stocks with high P/E ratios might seem like a good choice, it is important that investors keep certain things in mind.

One, high P/E can be the result of high share price and low EPS. If the share price of a company rises due to external conditions, it can result in a high P/E ratio. Also, if the company has generated low EPS but the investor sentiment has remained optimistic, P/E will be high despite the earnings being low. This can be misleading. Two, investors must remember that if the stock markets turn volatile due to external factors, the share price can increase/decrease, causing the P/E ratio to fluctuate. Thus, consider avoiding using this ratio during highly volatile times.

Investors also need to ensure that they analyse the company fundamentals before they take any decision.

The writer is Co-founder and COO, Groww

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