P E Ratio – Know What is Price Earnings Ratio

Most of us are eager to invest in shares. But we are not quite sure on how to begin. Share market is a very interesting subject and one must put efforts to understand the nitty gritty of investing. One can either be a trader or investor according to his choice and needs. To achieve our long-term goals, we can invest in equities/shares. By just opening a demat and trading account, anybody can start buying shares

Why companies sell shares?

For want of capital, companies issue shares to public. Anyone interested in investing in the company can buy shares in the primary market through IPO (initial public offer). Then this company gets listed on the stock exchange. The shares you bought can be traded in the secondary market. Based on market capitalization, companies can be large cap, mid cap or small cap. Depending on how much risk one can take, one can invest in a well-established company; investing in such companies is associated with low risk but the returns also won’t be too high. But if you want to safeguard your principal and do not intend to take risk, you can invest in large cap companies. If you have the capability to take high risk, you can invest in start-ups wherein you can get more profits or huge loss depending on the performance of the start-up.

How to select a stock?

Selecting a stock is very crucial and careful research must be done. You can either follow a top-down approach or a bottom-up approach. The economic conditions are given importance first in case of a top down approach and then a specific sector is chosen and finally a particular asset is selected whereas in case of a bottom up approach, you first analyses the company and then look at the macroeconomic picture. Several factors of the company must be analyses well before investing in it. The company’s financial statements must be understood to know the financial position and its future potential. Global, national, political and economic factors affect the price of a share in a positive or negative manner. Without having a proper knowledge of these, one cannot make any investment decisions.

Importance of Fundamental and Technical Analyses:

Fundamental analysis lets you know how strong the company is by decoding its financial position whereas technical analysis helps in prediction of stock price based on past price movements. The three assumptions in case of technical analysis are: Market discounts everything, secondly, price moves in trends and finally history tends to repeat itself. Both fundamental and technical analyses play an important role in understanding the stock price movements. Markets are volatile and the price of a stock may increase or decrease due to various factors. One must keep track of these to take the required investment decision such as buy, sell or hold. Usually, investors buy a stock when its price falls and sell a stock when its price increases. You should not take any decision simply based on rumors which may result in huge loss. Patience and clear understanding of the stock price movement is very essential. One should also know well when to exit a stock.

What is price to earnings ratio in a stock market?

Investing in shares must be done after careful study of the company. As you put your hard earned money in a company for a long term period, it is highly essential to know various factors such as the background of the company, the nature of its operations, its promoters, sustainability of the business, future plans of the company and more importantly you as an investor should know what the numbers in the financial statement signify. You need not be a commerce graduate to understand these. Any investor should know about PE ratio and EPS. Let us learn EPS first. EPS is Earnings Per Share and is calculated as follows:

EPS = Net Income- Preferred Dividends/No. of outstanding shares

A company with high EPS means that it is profitable, and it is in a position to distribute this profit to its shareholders. Hope you got a clear understanding of what role EPS plays in deciding the company.

PE ratio = share price/ EPS

Significance of PE ratio:

PE ratio talks about the growth potential of a company. High PE simply means that investors are optimistic about the future earnings of the company and are willing to pay more. It also shows that the stock is overvalued. Trailing PE and Forward PE are the two types that you should be aware of. In case of trailing PE, earnings of last 12 months are considered whereas in case of forward PE, earnings estimate over the next 12 months are taken into consideration. Let us learn PE ratio with a small example. Suppose, if a stock’s PE ratio is 5, it simply means that investors are ready to pay 5x of the company’s earning to buy it. PE ratio also tells how confident the investor is about the company’s future.

Companies that tend to have a high P and E ratio are said to be growth stocks. Investors feel that these stocks will do quite well in the future and so are willing to pay more for these stocks. As these stocks are overvalued, they are associated with high risk as well. Companies that have low PE ratio are said to be value stocks. PE ratio should not be the sole criteria for deciding about investing in a company, but everyone interested in investing shares should be aware of pe ratio meaning to make smarter investing decisions. By gradual practice, one can become an expert in choosing the stock. One must study and do a lot of research and take expert opinion before investing. Market reacts to several factors and stock price too is affected by macro and micro economic factors and all those must be taken into consideration.

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