Many investors believe that lower the P/E, the better a company to invest in! But, is it? It is kind of a habit that is so deeply engraved in the mind of investors especially beginner investors who think that a company with high price-to-earnings ratio turn out to be bad. And one should always invest in a company with low price-to-earnings (P/E) ratio. In this article, we will discuss how sometimes a low P/E ratio is not as beneficial as most investors think it is. But, first, let’s discuss how important is this P/E ratio?
What is a Price-to-Earnings Ratio?
It is a financial ratio that can be calculated as stock’s current share price divided by the earnings per share (EPS) for a one year period. This one year or 12 months is known as trailing 12 months. The P/E we use to calculate is an expression of the current share price compared with earnings of 12 month’s earnings. So, if a stock trading at Rs 60 per share with an EPS of Rs 2 then the P/E ratio would be (60/2) 30.
But, if the stock trading at Rs 120 per share with an EPS of Rs 3 then the P/E ratio would be (120/3) 40.
Why Companies have low P/E?
Generally, most investors believe that low P/E ratio of a company means that the company has huge potential and the stock of the company are certainly undervalued. It is the most common reason why we prefer to invest in a company with low P/E rather than a company with high P/E. However, there are other reasons for a low price-to-earnings ratio such as –
- Market Correction: Low P/E means the low price per share and high earnings. In a market correction, most companies become victims of undervalued share price despite having good earnings and profits. So, during that time, the P/E ratio can go lower in value which made investors believe that the company stock is undervalued.
- Company’s Reputation: Sometimes, investors are aware of the false tactics and strategies implemented by the companies which made their share prices surge in exchange. In such cases, the investors prefer not to invest in companies which automatically make their P/E value low and stocks undervalued.
Besides, the P/E value also depends upon industry-to-industry. So, even if you choose to invest in a company with low P/E value then make sure you compare the companies and their P/E values of the same industry.
Hope, the usefulness of this will help you better gauge what is a meaningfully low or high P/E ratio and would use this information in your fundamental analysis of stocks. Nevertheless, if you have any query or would like to add something up then don’t forget to mention in the comment section below.
Note: All information & data provided in this article is for the educational purpose as well as to give general information on the finance & economy, not to provide any professional advice or service. Views & opinions are not biased against the company and do not affect any official policy or any other agency, an organization within the content.