P/E Ratio For Stock Investing 

Basics of P/E Ratio

➤ P/E Formula

[PE Ratio = Price Per Share/Earning Per Share]

[PE Ratio = Dividing the current market price of a stock by the company's earnings per share (EPS)]

➤ For example

If a company's stock is currently trading at $100 per share and its EPS is $5, then the P/E ratio is 100/5, or 20. This means that investors are willing to pay $20 for every $1 of the company's earnings.

Often novice traders buy falling stocks having a Low P/E ratio because they are taught a simple rule “Low P/E means Stock is Undervalued”. In most cases, these stocks continue to fall and investors face heavy losses due to this “Bargain Trap”.

That's why it's important for investors & traders to understand the practical applications of the P/E ratio in order to avoid significant losses in their portfolios."

Check: S&P 500 PE Ratio

Understanding PE Ratio with Example

But it’s just a half-truth. Let’s understand the complete picture

There is a reason why one stock is trading at a high PE multiple and another at low PE multiple.

“Stock Market is a Forward Looking System or a Discounting Mechanism. It cares little about past and prices in future events/future outcomes.”

Generally, High PE means Investors are expecting that company’s future earnings will grow at a higher rate and a Low PE means Investors earnings expectations are relatively low.

On the basis of historical earnings, you can say that Tesla is overvalued compared to Toyota but the Market is interested in Futures Earnings Growth.

Tesla’s High PE is linked to the Investor’s perception of Tesla’s ability to expand earnings at a high rate.

In other words, you can say that the Price Earnings ratio measures the Level of Expectations or the Investor’s Perception of the future growth of the company.

Trailing Vs Forward PE (How to Calculate)

What is a Good PE Ratio? Is High PE Good or Bad?

You may have heard something like “Stocks with Low PE are attractive Investments” 

Historically, the average PE of benchmark indices like S&P 500 comes around so there is a general perception that a PE Ratio of 20 or below is good.

But the reality is that “there is no magic number of PE” or any objective rule for determining whether a company with a low price-to-earnings (PE) ratio is a good investment or not

In fact, In growth stocks, you will find out that the majority of Super performer Stocks had relatively high PE before their biggest advances. Look at the below chart of Tesla:

Tesla’s Stock Given Huge Returns When PE Ratio was high and it started falling badly when PE comes down.

The majority of value investors may have missed Investing in Tesla by looking at its High PE because of their misunderstood theory that “High PE Stocks are Expensive and Overvalued”

“In Stock Market, there is no Holy Grail or Magic Formula. Everything is Dynamic, Subjective, and Relative ”

Value Trap

A stock is down 40% from its recent highs. It has a PE Ratio of 5X against the Industry’s average of 20X.

What comes to your mind?

An amateur investor will think like 

“I should jump to buy this stock as I am getting a 40% discount”

If you also have similar thoughts then I want to tell you that this approach will lead to the biggest blunder in your investing journey.

Here is an example of Meta(Facebook) which fell 77% From Top:

• September 2021: Stock of Meta Platforms made a high of $385 when It has a PE Ratio of 28.
• March 2022: Thereafter stock started to fall and it was almost down 50% from its top when it has PE ratio of 14. 

If you solely invest based on PE Ratio, you might have invested in $META after 50% price drop as EPS was flat but price fell almost 50%. As a value investor, you might think that a $META is undervalued Stock at a PE of 14  as it was usually trading at PE of 28. 

Imagine What would be the result, a loss of 40-50% even after you invested at a discount of 50%

There is a reason why a stock is falling and what looks cheap may be the most expensive one.

Often stock prices are a reflection of a company’s future performance in advance.

Stock Price => Forward Looking => Leading Indicator 

Earnings => Historical Data  => Lagging Indicator 

Conclusion

In conclusion, here some insights about P/E Ratio that will help you in your Investing journey:

• PE Ratio is highly misunderstood and overused metric. It just simply tells you how a stock is priced compared to its earnings [Share Price/EPS]
•  It shows investor's perception about Company's future earning growth. Its normal for high growth stocks to trade at premium compared to the market or sector.
• In starting phase, many potential super-performance stocks has an unreasonably high P/E Ratio before their biggest rally. A high PE does not always mean that the Stock is Overvalued. 
• Stock Market is a forward looking instrument and discounting mechanism. Market participants tries to anticipate future performance of the company and it reflects it in Stock Prices. 
• In Stock Market, everything has to be seen in context. Sometimes a Company with PE of 100 are better than a company trading at PE of 5.
• Forward PE and PEG ratio are relatively better metrics than a Historical P/E (TTM PE).
• PE Ratio is not a magic formula and its just an another metric. To achieve high ROI, investor needs to follow a holistic approach and more focus should be on future outlook.

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