Every investor who trades in stocks, looks into this ratio and makes a call based on this ratio. Let me quickly give a background about this ratio. This ratio is nothing but, how much you are willing to pay for every rupee the company earns. This ratio varies from industry to industry. For example, technology companies are valued at a PE of around 25, whereas textile companies are valued at a PE ratio of 5.
Even within a sector, one company may be trading at a high PE, whereas another company may be trading with a low PE. Does it mean that the company with low PE is undervalued? The answer is ‘may be’. This is the lesson that we want to drive out of this post today.

PE ratio has its roots in three fundamental factors a) Growth b) Return on Equity c) Required rate of return (In other words the risk of a stock). Let me explain through an example. Assume there are two companies: Company A with earnings growth of 15% yoy; ROE is 20; Required rate of return at 17%. Let me assume this company quotes with a PE of 20. Whereas a company B with a growth of 7%; ROE of 3% and required rate of return of 20% is trading at a PE of 10. Let us assume the industry PE is 25.

Now we cannot claim that stock B is undervalued because the PE is driven by the above mentioned three factors which are bad for stock B. Whereas stock A despite its excellent fundamentals are trading at a discount to the industry average. Hence it makes sense to buy A as opposed to B.

Thumb Rule: ROE should be high; Growth should be high; Required Rate of Return should be low

From next time on, if your broker suggests you to buy a stock just because its PE is low, show your smartness by asking him what its growth is, ROE and Required Rate of Return!!