Price to earnings ratio is one of the most useful ratio for an investor/analyst. It gives us an idea of what the market is willing to pay for a company's earnings. So as this is the most useful ratio now let us try to understand it in detail.
First of all we cannot generalize by saying that a P/E of 50 or 100 is expensive or a P/E of 10 or 5 is cheap. It totally depends upon the growth of earnings whether that P/E is expensive or cheap. Without growth rate it’s meaningless to see this ratio. There are a multitude of factors too like Trend of ROIC/ROCE which affects P/E ratio. For a complete understanding of P/E decoding read complete Valuation Post 5 to Valuation Post 12.
Now let’s understand this with a set of examples:
In this above example (hypothetical) we have assumed that the company will earn INR 1 (constant) every year in the future.
Imagine the Current P/E ratio of the company was 20, that means you were paying Rs. 20 per share currently and the company will be earning Rs. 1 per share (EPS).
Now if you would have bought this company at the P/E of 20, think like a investor in how many years you would have recovered your capital, because it is the EPS which gets distributed to the shareholders/technically it is the earnings of the shareholders.
The answer as above table shows is 20 years - exactly the same as P/E ratio. So in short if the earning of a company does not grow neither declines - a P/E ratio can be defined as the number of years in which you will recover your capital back (not literally as the company may not give dividends but re-invest it back into the business)
Let’s take another example in which we have the same scenario as above but this time the P/E is 10 instead of 20 then what will happen?
This logic laid the foundation of the principle buy at Low P/E as who wouldn't want to recover their capital as quickly as possible.
“Remember one thing P/E ratio always affects your payback period”. Look at the above example by reducing P/E ratio the payback period also decreased from 20 to 10. In this scenario (P/E=10) our payback period has reduced (10 years) compared to P/E of 20. Likewise if you reduce P/E more, then the payback period will also decrease that’s why everyone in the market says buy at low P/E.
The P/E ratio of the company and the payback period were the same in above examples because we excluded the growth factor from the earnings.
A business is always done so that it can grow and bring in more profits for the coming years. Hence we will now take growth into account.
Now as we have learnt the base let us go deep into it and understand both the points from one example to get a better/ holistic idea. Let's take an example:
So with growth you can tell that a company A (with 5% growth and 20’s P/E) is seemingly expensive compared to other company B (20% growth rate & 20 P/E). Even though both may be in same industry and having same P/E currently Company B will turn out to be better investments.
This is one of the reason investing community chases high growth stock even at seemingly high current P/E's because returns are based on future growth and probability of this future growth actually getting delivered.
You can’t buy stock at any P/E without taking future growth rates into account otherwise you can end up paying much more than it is actually worth. For an investor, Purchase price is everything because returns depend on it.
Now let us create scenarios/ example of 4 companies and understand why purchase price matters:
If we observe the above example then we can rank companies according to their payback period like: 1) Company D 2) Company C 3) Company B and at last Company A right.
Have you noticed one thing from the above example that Company D despite having a P/E of 100 is a lucrative investment compared to company A, B and company C.
Also, Company C having a lower growth rate, of 20%, as compared to Company B, 35% growth rate, turns out to be a better investment.
The above two statements highlights a critical point that's to even simply judge a P/E requires a strong understanding of Current P/E levels & future growth rates the business can clock.
Obviously just growth alone can't determine what P/Es a business should be awarded in the market. There are other factors like ROEs, Leverage, Cost of Capital, Quality of shareholder, Float of stock, market leaderships, nature of risk etc.
For a complete understanding of P/E decoding read complete Valuation Post 5 to Valuation Post 12.