Understanding P/E for beginners?

Price to Earnings 

Many first time investors in the market are relying heavy on P/E to value the company.

Will it make sense to use P/E alone to make any considerable decision? What are the deficiencies in P/E to value a company?

Let us break all these jargons today.

First of all, if I give you two companies in the same sector with the following data will you able to find which is available at cheap and which has not?

Company Price EPS P/E
XYZ 100 5 20
ABC 50 2 25

Now, most of the investors will say XYZ looks a better company than ABC at least on P/E parameter. XYZ looks 20% Cheaper than ABC and if given choice, the next day you will go and buy this stock.

Hang On Guys. There is a catch. I will give you some more data and now try to find which one is cheap.

XYZ Company is growing at CAGR of 10% in the last 5 years whereas ABC Company is growing at CAGR of 20% in the last 5 years.

Will you buy a company which is growing at 10% or 20%? Obviously, 20 %, but as per P/E, this stock looks overvalued.

Now you need to understand why any company or in our example ABC Company is getting more P/E or value than XYZ. So, high P/E does not mean that the company is bad.

Let us deep dived more into it. Suppose, after one year the price of both stocks rises at the same rate of say 10%. The Table after one year will look like this.

Company Price EPS P/E
XYZ 110(10% Increase) 5.5(10% increase ) 20
ABC 50.5(10% increase) 2.4( 20% increase ) 21.04

So now it must be clear to all of us that the why growth company always command high P/E. After one year both the companies almost look at the same valuation and if you extend these figures to one more year you will be amazed to see ABC would look cheap. The real investors always see Growth in the business. Growth is the lifeline of any business.

Examples: The company such as Dmart, Bajaj Finance, and Delta corp always command high P/E owing to their growth. Please do the homework on the above companies and drop us a message if any doubt persists.

IZ-Note:  While valuing companies based on P/E always projects future growth as well to properly judge a company.