Understanding Price To Earnings Ratio (PE) In The Most Simplistic Manner

Most of you would have heard that we should buy when PE is below or near 12.5 and sell when it’s above 25-26 level (in case of indices).

But have you ever wondered how this range has been derived and is this a thumb rule which always holds and if it holds then why?

Let’s try to understand this concept.

PE stands for Price to Earnings Ratio and therefore, in order to calculate PE of any stock we need two things: the Price of the stock and Earning per Share (EPS). Usually, We can easily get PE of any stock but to make the basics clear I will take an example of say SBI

PE of SBI = Price of 1 share of SBI / EPS of 1 share of SBI

PE =303.85/26.29

PE =11.56

 

So what does this PE suggests to us?

It suggests that to get 1 Rupee of earning we have to pay 11.56

But before making any buying decisions based on PE we need to make it clear that PE is a relative term that is used in comparative analysis and not in absolute terms. We need some other asset class or stock to compare before coming to the conclusion of buy or sell.

For the sake of comparison let’s take another example of HDFC Bank

 

From the above data, it is clear that the PE of the two leading banks of our country is different.

One has a PE of 11.56, and the other one has 27.32

Therefore, to gain one rupee of earning in SBI, the shareholders are paying 11.56 rupees, while HDFC Bank shareholders are paying 27.32 rupees.

Does it mean that SBI is cheaper and good for investment?

I will leave this question for discussion and move forward.

Now let’s get back to the concept of Index PE

If we have to calculate the PE of an index, we will use the same formula as we used for the stocks.

PE= Price/EPS

The value 39.34 for NIFTY (see chart) here means that in order to earn one rupee, Nifty investors are paying 39.34

 

 

The value 39.34 for NIFTY here means that in order to earn one rupee, the Nifty investors are willing to pay 39.34.

Now that we have the data, how do we interpret this data? And as we said that PE should be used as comparative data – with what we should compare to come to a conclusion.

Here is the answer.

 

Usually, an investor has two choices: Fixed asset class and Risky asset class.

When we talk about the fixed asset class, a 10-year government bond is considered the safest fixed asset class.

How can we say that? Let’s have a look by calculating the PE of 10-year government bonds?

The current bond yield is 6%, which means to earn 6 Rupees, the investor has to pay 100 rupees.

So PE comes out to be 100/6= 16.7

Therefore, in the fixed asset class, one has to pay 16.7 to earn 1 rupee.

In the risky asset class, that is, GDP (Sensex /Nifty), PE at present is 39.34 (calculated above). This means to earn 1 Rupee, you will have to pay 39.34.

The logic here is that whenever PE of a fixed asset class and risky asset class comes at the same level, you will be paying some money to gain one rupee. Still, there will be an advantage if you are putting your money in Sensex /Nifty.

That advantage is that the earnings growth in Sensex/Nifty will either decline or remain stagnant in the fixed asset class.

Therefore, from the above discussion, we can conclude that it is always logical to buy Sensex /Nifty when its PE comes near or below the fixed asset class.