Picking a good stock is combination of two things: you want to pick a well-run and profitable company but you also want it at a good price. It's pointless to look at either variable without considering the other. It's no good picking a great company if its stock price is priced very high by the market and it's no good picking up a cheap stock if the company is a dud.

That is where the P/E ratio comes in; it's a single measure which gives you information about both the profitability of the company and the price of its stock. It's a great starting point when you are trying to pick a good stock at a reasonable value.

What exactly is the P/E ratio?

P/E stands for price/earnings and the concept is quite straightforward. The numerator is simply the price per share and the denominator is the earnings (or profits) per share or EPS. So if a stock has a price of Rs 100 and the firm has an annual EPS of Rs 10 then the P/E ratio is 10.

Another way of looking at is that the P/E ratio tells you how much you are paying for every rupee of earnings from the firm. If a firm has a P/E of 15 it means you pay Rs 15 for every single rupee that a company earns as profit.

Interpreting the P/E ratio

In general the lower the P/E ratio the better value for money the stock represents. Roughly a P/E of around 15 would be considered normal. A P/E above 20 would be considered expensive and one below 10 would be cheap. However you have to make a few adjustments.

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It may be possible that a particular company while having relatively high earnings today has poor future prospects, say, because of poor management. The markets would push down its stock price leading to a low P/E ratio but the stock isn't necessarily a good buy.

Secondly you have to adjust for the industry in which the company operates as well as its general growth prospects. 'Old Economy' industries like steel and cement generally have low P/E ratios because these industries are considered to have only moderate growth prospects. 'New Economy' industries like IT and telecoms have high P/E ratios because they have excellent growth prospects.

When evaluating a company it makes sense to compare its ratio with that of other similar firms in the industry. You may also want to compare a firm's P/E ratio with its ratio in previous years; if its P/E today is significantly lower than, say, the three year average then it may be a good buy.

PEG ratio

Another variant of the P/E ratio that is sometimes used, especially for high-growing industries, is the PEG ratio. This is the ratio of the P/E number calculated above to the expected annual growth of earnings in percentage terms.

So for example if the price of a stock is Rs 90, the EPS is 3 and expected growth is 40 per cent, the P/E ratio is 30 and the PEG ratio is 30/40 or 0.75.

The PEG ratio is especially useful for high growth industries like information technology.

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The lower the PEG ratio the more attractive the stock is and in particular a PEG less than 1 is often considered attractive. So for example an IT stock may be an attractive buy even with a P/E ratio of 30 if you expect earnings to grow at more than 30 per cent in the future.

A cement stock may not be good value even at a P/E ratio of 10 if future growth prospects are poor.

Of course measuring future earnings is tricky. You can start by looking at earnings growth in previous years but there is no guarantee that the firm will be able to sustain such growth in the future.

This is where judgment comes in; you have to evaluate the future prospect of the industry and also whether the firm has the right strategy to exploit opportunities.  

Conclusion

The P/E ratio is perhaps the single most important ratio in fundamental analysis. However it can't be used blindly. As always in stock investing you have to combine ratio analysis with careful judgement about the firm's management and future prospects.