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Whether PE ratio is enough to justify investment?

20 Dec

This precise Article on stock trading is the tri-sectional combination of my experience, acquired knowledge and Intuition. My Readers may be, possibly, more knowledgeable in stock trading rather than me. Even though I dare to put my ideas particularly on P/E ratio, relied upon the most by investors and analysts as one of the important factors to ascertain a quality stock. But, in my opinion, to emphasize this only tool is not wise for a better choice as it may prove to be imperfect just as in a folk story of “Blind men and an elephant”.

Price-Earnings (PE) Ratio is a primary indicator of how much a particular stock is cheap or expensive to deal in or compare with having similar price or sector. Its calculating formula is as PE=Market Price/EPS. In simple way, you may say how many times more the price you pay to earn INR 1 or a unit of any other currency. But, to rely upon P/E solely is risky. PE ratio only can never give you a clear picture of company’s performance. You should take into consideration some other profit indicators also while putting your money into a flaming (!) stock market.

Just to maintain spread of the topic, I’ll continue on the tool of PE only. Base figures of Market Price and EPS (Earning per Share) are authentic but not too effective in this calculation. Market price changes every minute, day or month. Similarly, figure of EPS also fails here as it may be of the previous year/quarter ending. Some analysts calculate average of past four quarters and in modified way past two and two future quarters with projected EPS. What it may be, but it is very clear that EPS figure is delusive and market price is always unsteady.

PE may be a good indicator to start searching a good company but not always a fool-proof tool. PE is the result of past figures and market price is variable aiming to future sometimes. Any company’s EPS may be poor, but its future growth may be bright and this factor may provide fuel to move its price to higher side. EPS of some companies may look lucrative like mirage in desert in case of their other income occurred due to the sale of the assets and they inflate their profit figures highly.

For most of the people, stock trading is their part time activity and it is not possible for them to investigate any stock in its depth. Studying fundamental and technical analysis is the job of the Analysts and Fund Managers. My aim of this brief Article is just to warn investors not to follow PE blindly. They should not overlook other factors such as stable growth, steady profits, regular dividend payments, ROE (Return on Equity), PEG (advanced to PE), Book Value etc. over and above EPS and/or PE.

Regards,

– Valibhai Musa

 
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Posted by on December 20, 2008 in Article

 

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