P/E Ratio in stock analysis
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P/E ratio or the Price to earnings ratio is the criteria which is used to compare with various other factors or is itself observed to understand weather a stock is undervalued or overvalued based on its share price. It can be calculated by simply dividing the price of the stock by the earnings per share of a stock.
P/E= Share price / Earnings per share
The P/E ratio helps investors determine the market value of a stock as compared to the company's earnings. In short, the P/E shows what the market is willing to pay today for a stock based on its past or future earnings. A high P/E could mean that a stock's price is high relative to earnings and possibly overvalued. Conversely, a low P/E might indicate that the current stock price is low relative to earnings or undervalued.
However P/E ratio always individually can't be used to determine the value of a stock since sometimes a high P/E ratio could also show the sentiment and expectations of a investor from the stock and a companies growth capabilities. This criteria also can't be used to measure the value of a small cap companies. Hence a high P/E ratio doesn't necessarily mean a over valued share. However, when we look at the Indian stock markets the nifty trading at a high P/E ratio of about 26 or above could also mean that soon the market is looking for a profit booking or a small correction anytime soon.
As stated earlier, to determine whether a stock is overvalued or undervalued, it should be compared to other stock in its sector or industry group. Sectors are made up of industry groups, and industry groups are made up of stocks with similar businesses such the IT sector, banking and finance sector or the construction sector, etc.
If a stock is trading below it's industry P/E than the stock is expected to grow well in it's near future to match the industry P/E if it's other growth fundamentals show strong support.
P/E ratio could also be used for calculating the PEG ratio. Now, what is this PEG ratio? A P/E ratio, even one calculated using a forward earnings estimate, does not always show whether or not the P/E is appropriate for the company's forecasted growth rate. To address this limitation, investors turn to another ratio called the PEG ratio.
Now let's look at how does this determine the value of a stock.
PEG ratio= PE ratio / Estimated growth rate
Now let us firstly divide the stocks into good or well performing stocks, neutrally performing and bad performing stocks and look at it's comparisons with the PEG ratio.
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