When an investor is associated with capital market, he/she comes across a number of financial indicators and tools. Investors should, thus, encompass the knowledge on such tools and techniques. One of these financial metrics upon which Nepalese investors place a major emphasis is Price-Earning (P/E) ratio.
P/E ratio basically measures a company’s market price of shares relative to its corporate earnings. The calculated P/E ratio can further be used to make the right investment decision if one compares the calculated P/E ratio with the P/E ratio of another company operating in the same industry.
P/E ratio shows the investor’s willingness to give up a certain amount to attain the return of Rupees 1. For instance, if a company has a P/E ratio of 54, this implies that an investor is willing to invest Rs 54 in order to gain the return of Re. 1.
Financial analysts have developed a formula to calculate P/E ratio i.e. Market Price of share of a company divided by Earning Price of Share of the same company.
P/E ratio carries a significant importance while analyzing the investment decision. However, the interpretation of P/E ratio differs from one investor to another. A higher P/E ratio might imply either the company’s shares are overpriced or that the company’s management and operation is so sound that it deserves the premium value of earning. In contrast to this, a lower P/E ratio might indicate either the company’s shares are underpriced or the company is performing better compared to the past trends.
A beginner in the capital market with less amount of cash in hand can go for a company with low P/E ratio as the beginner can invest only few penny to get the desired return. Similarly, experienced investor who expects higher growth in the future can choose company with high P/E ratio. However, the investors also need to test out whether the share price is overpriced or underpriced. This can be done by comparing the price of the individual company’s share with the average historical price of shares of the whole industry.
However, investors often let go the fact that every financial tool has its own drawback. P/E ratio is also not free from its limitations. If any investor is making investment decision taking P/E ratio into consideration, he/she should compare the P/E ratios of companies within the same industry as such comparison will only lead to productive insight. Therefore, comparing P/E ratio of banking sector with hydropower sector will not provide an accurate estimate. Similarly, investors can rely more on P/E ratio if the investment is for long term instead of short term. Investors often rely only on one indicator to make investment decision. Thus, relying solely on P/E ratio will not provide investors with meaningful return. For instance, a company that possesses higher debt is likely to have a lower P/E ratio; however, if the company has an efficient business model and operation, it is likely to attain higher earnings in the future from the credit risk it has taken.
P/E ratio can thus, give you an understanding of whether a share is worth buying or not. It can help you expand your investment portfolio; however, the considerations of several other aspects of the business are also to be taken.
