DRY (US Securities Commission) has defined the price/earnings ratio as a number that compares the price of a company’s common stock to its earnings per share.

Now, to calculate and use the price/earnings ratio to make investment decisions, the following steps can be followed sequentially:

1. Calculate the P/E ratio–

Have a stock’s market price (MPS) in the numerator and earnings per share (EPS) in the denominator and this becomes the stock’s P/E ratio.

Example: Yes, MPS for Wal-Mart Stores Inc (WMT) is $77.8150

Wal-Mart Stores Inc (WMT) EPS is $5.07

That’s why,

P/E Ratio (WMT) = MPS (WMT) /EPS (WMT)

= $77,185 / $5.07 = 15,224

two. Interpret the P/E ratio–

(a) If we talk in mathematical terms, the price/earnings ratio simply shows how many times the market price of a stock is relative to its earnings per share. However, for investors it has more to do with the valuation of a stock from an investment perspective. P/E ratio responds accurately how much an investor is willing to pay to buy a company’s earnings in dollars. Based on the example above, investors are willing to pay $15,224 to buy $1 profit at Wal-Mart stores.

(b) The price/earnings ratio reflects the general sentiment of investors about a stock. A high P/E ratio shows that investors are eager to buy the stock as they expect the company to have a promising future outlook, and will ensure consistent future performance with an attractive growth rate. Conversely, a low P/E ratio means just the opposite.

(c) A P/E ratio below 10 is considered low and means the stock is cheap; the range of 10-15 can be considered a fair price, and a price/earnings ratio between 15 and 20 indicates that the stock is expensive.

3. Comparison leads to better interpretation–

However, the relationship becomes more significant when compared to the industry price/earnings ratio or at least to the average price/earnings ratio of some representative companies of the specific industry sector. It would be unwise to compare Wal-Mart Stores Inc’s P/E ratio of 15.224 with Pfizer Inc’s P/E ratio of 13.5878. Rather, it would be more meaningful if Pfizer Inc’s P/E ratio of 13.5878 was compared to Johnson & Johnson’s P/E ratio of 17.5392, as both companies are in the health care, biotech and pharmaceutical and both are subcategorized as big pharma. This comparison would accurately reflect the fact that investors have higher expectations of Johnson & Johnson regarding its future outlook, revenue growth and returns to investors than Pfizer. Here, the comparison of these two ratios also indicates that Pfizer stock is cheaper than Johnson & Johnson stock. Along with this, if industry/sector averages are considered, that would further increase the quality of the investment valuation analysis.

Four. Standalone P/E Ratio Can Be Misleading–

Warren Buffet has not given much weight to price/earnings in isolation for valuation purposes. His point of view is evident in Berkshire Hathaway’s Annual Report for the year 2000. There he argued that price/earnings and other common criteria will simply provide clues to the amount and timing of a company’s cash flows and nothing more. that this. as far as valuation is concerned.

Shawn Allen, in his article “Warren Buffett Claims P/E Has Nothing To Do With Valuation,” published on InvestorsFriend.com (September 14, 2001), defends Buffett’s view. He prescribes that instead of using an incorrect P/E ratio, it is better to use a normalized P/E ratio along with EPS growth rate, dividend payout ratio, etc.

In fact, using the PEG ratio (P/E ratio / EPS growth rate) with staged growth rates would give a better picture of the stock. However, if a company’s future cash flows can be predicted, the best way to measure the degree of stock overvaluation or undervaluation would be to calculate the intrinsic value of the stock and then directly compare the existing stock price to that value. to conclude if it is a bargain.