What is PE Ratio? The Price Earnings ratio popularly called PE Ratio, is a popularly used value indicator used by stock market investors in India. Stocks which have a lower PE Ratio are believed to have a cheaper current price, than stocks which have a higher PE Ratio.
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Why is PE Ratio important? PE Ratio tells you how much you pay for a single rupee of a Company’s earnings. A stock with a PE Ratio of 15 means you are paying 15 Rupees for every one rupee of Company earnings.
PE Ratio = Market Price per share / Earnings per share.
Let’s calculate the PE Ratio of Rain Industries:
Price of Rain Industry share = Rs 200
Earnings per share = 6.65
Rain Industries PE Ratio = 200 / 6.65 = 30
Let’s calculate the PE Ratio of Ambuja Cements
Price of Ambuja Cements share = Rs 853
Earnings per share = 19.39
Ambuja Cements PE Ratio = 853/19.39 = 44.
You find the PE Ratio of Ambuja Cements is more than the PE Ratio of Rain Industries. This is because if you buy a share of Ambuja Cements, you have to pay Rs 44 for each Rupee the Company earns, whereas if you buy a share of Rain Industries, you pay just Rs 30 for each Rupee of Company earnings.
Let’s say shares of a Company XYZ = Rs 100
Let’s say shares of a Company ABC= Rs 200
According to observations, shares of Company ABC are more costly than shares of Company XYZ. But is this true?
Let’s take a look at the PE Ratio. Let’s assume Company ABC has a PE Ratio of 10. Company XYZ has a PE Ratio of 20.
This means if you buy the shares of Company ABC, you pay just Rs 10 for every Rupee earnings of the Company. If you buy the shares of Company XYZ, you pay Rs 20 for every Rupee earnings of the Company. This means even though shares of Company ABC cost Rs 200, a P/E ratio of 10 makes it cheaper than shares of Company XYZ, which have a P/E ratio of 20, even though price of the share is just Rs 100.
Just because a Company has a low P/E doesn’t make it cheap. A Company may have a low P/E because its business is not doing too well or it’s suffering heavy losses. Clearly P/E Ratio alone is not enough to decide if the shares of the Company are a good buy.
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