FFB-Post 23
The Price to Earnings Ratio (P/E Ratio) is a vital tool in the investor’s toolkit. Unlike the Price to Book Ratio, which focuses on a company’s asset value, the P/E Ratio assesses how much you’re paying for a company’s ability to generate earnings. The goal is to ensure that you’re not overpaying for a business in relation to how much profit it can produce, allowing you to break even on your investment as quickly as possible.
How the P/E Ratio is Calculated
Let’s break it down with an example:
- Suppose a company can generate a profit of ₹5,000 annually.
- You offer ₹50,000 to buy the business.
- The P/E Ratio would be 50,000 ÷ 5,000 = 10 times the earnings, or a P/E of 10.
Now, if the owner demands ₹100,000:
- The P/E Ratio would be 100,000 ÷ 5,000 = 20 times the earnings, or a P/E of 20.
The Goal: Buy Low, Earn Faster
The lower the P/E Ratio, the better. A lower P/E suggests it will take you less time to recover your initial investment through the company’s earnings. However, it’s essential to note that different industries have different growth expectations. For example, the tech industry typically grows faster, so finding a tech company with a low P/E Ratio might be challenging.
Determining a Good P/E Ratio
To determine if a P/E Ratio is favorable, consider these steps:
- Historical P/E Ratio: Look at the company’s P/E over the past 10 years. Suppose the average P/E is 20.
- Margin of Safety: Apply a margin of safety by multiplying the average P/E by 0.7 (30% discount). In this case, 20 x 0.7 = 14.
- Check Earnings Per Share (EPS): EPS is calculated by dividing the company’s total profit by the number of outstanding shares. Let’s assume the EPS is ₹4.
- Calculate Target Price: Multiply the EPS by the safe P/E Ratio you calculated. In this case, 4 x 14 = ₹56.
So, if the company’s stock price drops to ₹56 or lower, it might be an excellent opportunity to invest.
Summary: Using the P/E Ratio
- Step 1: Look up the average historical P/E Ratio of the company (over 10 years).
- Step 2: Apply a 30% margin of safety (multiply by 0.7).
- Step 3: Find the current EPS.
- Step 4: Multiply the results of Step 2 and Step 3 to find your target purchase price.
If the stock price falls below this target, it could be a wise buy.
Coming Up Next: Dividend Yield
In the next post, we’ll dive into understanding Dividend Yield and how it fits into your investment strategy.
Stay tuned!
For Post 24 – Click Here -> Dividend Yield