How to use Price to Earnings Ratio to Pick Stocks

Investors are always in search of such companies or stocks which may give them a  multibagger return in the future. They use several parameters at the time of selecting such stocks. The price-to-earnings-ratio or P/E ratio is a vital and useful metric among investors. Here we will understand the P/E ratio and how to use Price to Earnings ratio to pick stocks which may yield multibagger return in the future.

What is Price-to-earnings Ratio

Let’s assume, a company has a net income of $10000 per year. It Pays $5000 in preferred dividend to investors. It has 50 shares outstanding.

Earning Per Share

Now, if the stock currently trades at $1000, then

Price to earning Ratio

So, a holder of single share or stock will receive a dividend of $100. Therefore, the dividend yield percentage  =  $100 × 100%/$1000/-     = 10%.

So, you have earned a 10% return on your investment of $1000 in stocks.

How to calculate the Price-to-earnings Ratio across different sectors

When dividend yield of a stock increases, it means the company is making profit year on year basis. Regular profit indicates a company’s strong fundamentals, good management and of course reliability. After analyzing the overall features of that company, it can be concluded that the company is promising. In general, most of the investors prefer stocks with lower P/E ratio irrespective of sectors. On the other hand, some investors watch out several sectors as well as stocks which have higher P/E ratio instead of those sectors where industry’s P/E, as well as stocks, is low. This is just like a comparison between apple and orange.

Let’s clear it with an example.

It is a herculean task to establish a software company. The software company requires quality technical skill, a better team, a good management and after all the parameters which satisfy the stringent government policy.  After tackling all the difficulties the company has to deliver best quality service and must have the ability to tackle the competition from the existing big guns already present in the sector. But any how if you get successful to establish the software company there is least chance of facing competition from other companies. Since there are few companies operating as there is a strong entry barrier to set up a software company and get succeed. But once you establish your reputation and succeed you will have lesser competition and the sector has a huge potential.

On the other hand, if you are in the restaurant sector then you will face a hard completion forever, since this sector has no strong entry barrier and it is quite easy to set up a restaurant. Practically, all sectors with high P/E ratio do not mean that they are overvalued. The market is bullish on these sectors due to robust earnings growth, profit margin, and inches towards higher levels. They are able to deliver steady returns in the near future just because of their business model, management quality and after all the future potential of any specific sector.

In Addition to,

The lower P/E ratio of sectors does not mean that this sector is undervalued and they are going to boom and deliver multibagger return in the near future with compared to that sectors which have higher P/E ratio. These sectors have higher valuation just because the market is bullish on these sectors and their future potential like Automobile, FMCG, Petroleum, etc. As they are core sectors of the Indian economy and have the potential to deliver robust performance in the upcoming years.

Where you should Invest

You can invest in such companies or stocks which have low P/E ratio compared to stocks with high P/E ratio after analyzing the factors like Debt ratio, Compounded Sales Growth, Compounded Profit Growth, Market Cap, and Return on Equity, management etc.  Suppose you want to invest in paints and pigments sector. After fundamental analysis you notice that Asian paints satisfy all the conditions, but has a high P/E. So you decide to invest in paints sectors which have a strong entry barrier.  This sector will be able to deliver steady returns in the near future.  You should search for such company or stock which has strong fundamentals i.e., Debt ratio, Compounded Sales Growth, Compounded Profit Growth, Market Cap, and Return on Equity etc. 

Finally,

It is suggested to view the P/E ratio as the market’s reaction to a particular company or sector’s growth potential. A lower P/E ratio of a company may be an indication that the market is expecting that the company to head trouble in the near future. On the other hand, a high P/E ratio does not mean that this company or stock is overvalued. It can be concluded that the market is optimist on that company or stock. But if the numbers do not cope with market expectations then the market will punish the stock and inches towards lower valuation. High P/E ratio of stocks implies the growth stocks and low P/E ratio implies that these stocks will deliver steady return in the near future.

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