Is PE a good measure of valuation?

A market price of a company’s stock may be in single digit or in two, three, four or even five digits. So, is a stock price in single digit or two digits cheaper than a stock price in three or four digits? On the face of it, it does appear that a stock priced at, say, Rs 5 or Rs 15 is cheaper than a stock priced at Rs 150 or Rs 1050. But does it mean that a stock of Company A priced at Rs 150 is highly valued by the market than the stock of Company B priced at Rs 15? Well, not really. This is because the price of a stock has to be seen in relation to the earnings per share (EPS) of the company. The EPS divides the net profit of the company for the year by the number of paid-up shares, so if the entire year’s profit is distributed among shareholders, they would get the EPS amount as dividend.

In the above example, if the EPS of Company A (stock price Rs 150) is Rs 50, and the EPS of Company B (stock price Rs 15) is Rs 2, the price-to-earnings (PE) ratio works out to 3x for Company A and 7.5x for Company B. Clearly, the valuation of Company B is much higher than that of Company A, although the stock price of the latter is 10 times higher than the former. So, PE evaluates the price of a stock in relation to the earnings of the company, thereby giving us a fair picture of a stock’s valuation.

But does it mean that high PE stocks are overpriced and low PE stocks are undervalued ones? Not necessarily. The valuation of a stock needs to be seen in the context of the financial performance and the future prospects of the company.  So, one needs to do a fundamental analysis of the company to ascertain whether or not the valuation is justified.

There is yet another measure to find out whether a stock is overvalued, undervalued or fairly priced. Known as the price-earnings growth ratio (PEG ratio), it is arrived at by dividing the PE of the company with the earnings growth rate for a specified period. If the PEG is higher than one, the stock is deemed to be overvalued, if it is less than one, it is considered as undervalued and if it is equal to one, the stock is deemed to be fairly valued.