When we talked about PE ratio, you told me that it can be used to judge whether a stock is over-priced or under-priced. So, does a low PE mean that a stock is under-priced, and a high PE mean that the stock is over-priced?
Not really. Just knowing a stock’s PE ratio doesn’t help much. You cannot say that a stock with a PE of 5 is inexpensive, or a stock with a PE of 50 is expensive.
How exactly can the PE ratio be used then?
A stock’s PE ratio should be compared with the PE ratio of similar-sized companies from the same sector. If it is higher, the stock may be over-priced, and if it is lower, the stock may be under-priced.
A stock’s PE ratio can also be compared with its own PE ratio from the past to determine if it is over-priced or under-priced based on whether it’s going up or down over time.
Should I use trailing PE ratio, or forward PE ratio?
Both trailing and forward PE ratios can be used for your analysis. A forward PE ratio can give a better idea about valuation because it takes the company’s future into account, but it can also be inaccurate because your estimate of the company’s future EPS could be incorrect. A trailing PE ratio is very accurate, but doesn’t take the company’s future into account. Whichever PE you decide to use, use it consistently for all companies during your analysis.
What are the factors that impact a stock’s PE? What decides whether it is high or low?
There are many factors that influence a stock’s PE. In a bull market, PE ratios of most stocks are high. On the other hand, PE ratios of most stocks are low in bear market.
One thing you should keep in mind is that companies that are expected to grow at a fast pace tend to have a higher PE ratio compared to mature companies with stable growth, because people are willing to pay more for the future higher profit of such a company.
To continue the same logic, companies in growing sectors – like technology – usually have higher PE ratios than companies in mature sectors, like textile manufacturers.
So, can I make a buy or sell decision based purely on the PE ratio analysis?
PE ratio is only a starting point. You need to perform further analysis to determine why the PE ratio of a stock is high or low. You would use other indicators like the company’s growth rate, its dividend payment, the industry it operates in, etc for this. This kind of analysis is called fundamental analysis. But that’s a topic for another time…