When will the market be ready to make money for you?. A valuation ratio, Price to Earnings ratio commonly known as PE ratio. The ratio literally means how much you pay for a company to earn the whole minimum denomination of your currency ($1 or ₹1).
For example, Everyone’s favorite stock ITC is trading at a P/E of 16.93 with a close price of ₹211 on 5th Jan 2020. The net income per share directly from the balance sheet is 12.46. You pay ₹211 to the firm to make a profit of 12.46. In another way, you are willing to pay ₹211 to a company which can produce a profit of 12.46.
The ratio fluctuates every quarter, which is directly affected by the earnings. The other parameter is the price which varies every second within the trading period. The blog isn’t about the ratio, but to widen your perspective on the number and what it tries to tell you.
Are retail investors ready to pay lofty amounts for acute earnings?? If you say NO, you will miss your fortune living a millionaire life. Because certain stocks trade at high levels due to market mood. To scoop gains, your first action is to stay dormant and wait for the price to correct, then open your arsenal to shoot at the lowest unpredictable price.
The ratio is available for the index itself, consisting of companies with which the index oscillates. The costliest being the mid-cap trading at 300 times the earnings, the cheapest will always be the public-sector index which comprises the PSUs. The prominent and well-known index Nifty 50 currently trading at 38.55. For the Indian Capital market, especially NSE average extravagance was 22.38 and of BSE 20.22.
Fine, knowing the basics and examples will do no good, but help you in understanding the bigger picture.
The higher you pay, the less you make. If you invest in a stock that has a PE of 30 which you expect to increase by some value, less certain its going to happen. The corresponding P/E expected is called Forward P/E. The meat is, no stock can survive on high PE unless the High Net worth Individuals (HNI) and bigger FII or DII are interested to pump the stock. If you buy high, you are less likely to make profits than expecting a reversal.
What this number have to do with the profits?? An oddity that had been tabulated below is an observation dated back to 1898 providing us data for a century.
The averaged numbers of the total return for the decade say it all. Whenever the market gets costlier, PE rises while earning stick to the previous quarter results. The PE below 20 has given higher returns than the rest of the numbers. Inflation is for everyone, and the numbers are reliable. If the buying price of raw material grows, eventually the selling price will. The table drafted is for American stock exchanges but the happenings are the same. Tabulated by Robert J. Shiller, Noble laureate, Professor at Yale, USA.
This doesn’t mean that the stocks trading under 20 will make profits because the index is a number averaged from the underlying stock\’s performance. PE is not the only parameter to buy a stock or to value the company. It’s a hit in the face saying you are making a trade involving more money for fewer earnings.
If you are taking away anything from here, that should be, Always pay less for better profits. This brings us to the paramount saying: Buy low, sell high.
People tend to buy at higher PEs neglecting the major indicators. When the price decreases they rush to sell at lower prices exiting with loss and brokerage additionally.