Should you buy a company with a Price Earnings Ratio (P/E) greater than 20?

Should you buy a company with a Price Earnings Ratio (P/E) greater than 20?

(According to NSE data, the NIFTY 50 PE ratio for the month of May was 21.4)

The P/E ratio, or price-to-earnings ratio, is a widely used valuation metric in the stock market that helps investors determine whether a company’s stock is overvalued or undervalued.

The P/E ratio is calculated by dividing a company’s stock price by its earnings per share (EPS). It essentially shows how much investors are willing to pay for each rupee of a company’s earnings.

For example, if a company’s stock price is INR 50 and its EPS is INR 2, the P/E ratio would be 25 (50/2).

However, P/E ratio should be used along with other stock factors such as,

(a) Industry Comparisons:/ P/E ratios are typically compared within the same industry, as different industries have varying growth rates, risks, and capital requirements, which affect their P/E ratios.

For instance, the internet business Amazon’s P/E ratio of 50 and Ford Motor’s P/E ratio of 12 are not comparable.

(b) Growth expectations: / Companies with higher growth prospects tend to have higher P/E ratios, as investors are willing to pay a premium for future earnings growth.

For example, the internet business Amazon’s P/E ratio of 50 and Walmart’s P/E ratio of 28 may be justifiable due to scalable business model, a strong distribution network and a focus on innovation.

(c) Cyclicality: / P/E ratios tend to be higher during economic expansions and lower during recessions, as earnings are typically higher during good times and lower during bad times.

For example, Zoom’s P/E ratio, for instance, was 80 times higher in Covid than it is currently 23.51 times.

(d) Earnings quality: / The P/E ratio should be evaluated in conjunction with other financial metrics, as it does not account for the quality or sustainability of a company’s earnings.

For example, Google’s P/E ratio, for instance, is at 33 times than IBM’s P/E ratio currently 18 times. (Retail vs Enterprise cash flows)

Please share your experience and insights on P/E ratio.

(US stocks are chosen for better comparisons).

Sources

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