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Understanding P/E - A Layman's explanation


On the channels you must have heard of many jargons, and the most heard of them is P/E Ratio (Low PE, High PE etc..), what is it and how its important? After reading this article you may also start looking at PE before investing your hard earned money in stock market.

Mathematically PE is calculated by dividing the current market price of the stock by its earning per share (EPS). 

PE = Stock price / EPS* 

(*Will try to write an article on EPS later on)

It shows the sum of money markets are ready to pay for each rupee worth of the earnings of the company. The higher the P/E the more the market is willing to pay for the company’s earnings. And on the opposit side Lower the PE means market does not have as much faith in that company stock.

On the flip side higher PE stock also means that further growth prospects are low and Low PE means that company has head room for markets to pay a higher price for its stock in future.

In short High PE stocks means over priced or fully priced stock and low PE means cheap stock.

In laymans term let me give an example, Suppose Fully Ripe mangoes are available for 100rs/kg and Unripe (Green) mango is available for 60 rs/kg. So one can buy unripe mangoes and wait for them to get ripened, but there are chances that some of the mangoes may not ripen. So there is a risk in buying unripe mangoes, but there are potential savings as well if you pick the right ones ;-)

Ofcourse PE alone cannot be the base of an investment rationale as it alone does not tell the whole story, but it throws light on the relationship between the stock price and the company’s earnings and gives investors a view of further growth potential in a stock. 

Apart from the companies PE ratio, also look at the sectors PE ratio. E.g. Check for Real Estate Sector PE ratio and then Check for DLF or Unitech PE ratio, this will give an idea of a companies investor faith or growth potential vis a vis the sectoral view.

Also always keep in mind that market is never wrong as its collective wisdom at play.

* This is my old blog which i've now put it under my - Layman's series

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