Hidden risk in investing in high P/E stocks
Every investor, be it in any stock market across the world, would have come across several stocks that trade on a high price-to-earnings (PE) ratio. The PE ratio sometimes crosses all reasonable levels of valuation logic, even crossing levels of 100! Let us look at the risks of investing in these high P/E stocks.
Understanding the P/E ratio:
What is a high P/E ratio?
Investors paying Rs 20 to get a Re 1 share in the earnings of the company is an example of the P/E ratio. This can happen if investors are certain that the company will generate more profits in the future. Hence, the demand for the stocks of the company increases leading to an increase in price rises, allowing them to earn capital appreciation along with regular income in the form of dividends. Hence, the P/E ratio is a good way to get a glimpse into the way the market perceives a specific stock.
However, P/E ratios are not standalone measures. In fact, every industry or sector can have different P/E ratios. Hence, there is no standard measure of a high P/E ratio. It is always in comparison with the company’s competitors and its peers. If you look at the FMCG sector, most companies have a P/E ratio between 25 and 50. So, if a company trades at a P/E ratio of 60, it is said to be trading at a higher P/E and if it is trading at a P/E of less than 25, it is said to be trading a lower P/E ratio.
Things to keep in mind while investing in high P/E stocks:
As you can see, stocks with higher P/E ratios seem like better investment options. However, you cannot merely rely on the P/E ratio to make an investment decision. Here are some essential things that you must keep in mind before you invest in a high P/E stock:
The stock can be overvalued: Since P/E is a ratio, a higher numerator or lower denominator can result in a higher P/E.
The numerator (share price) – If the market price of a stock increases due to reasons beyond the performance of the company, then the P/E ratio will be higher. However, it might not resonate with the company’s performance and the demand might not be sustained for long.
The denominator (EPS) – EPS is the ratio of the earnings of a company to its outstanding shares. If the company issues more shares, then its EPS can drop. This can boost the P/E ratio of the company. Also, if the company has lower earnings in a financial year, then its EPS will be low, causing a higher P/E ratio. Typically, most investors analyse the popularity and demand of a stock by looking at the company’s P/E ratio in comparison with its peers. However, as you can see above, a company with lower earnings can also have a higher P/E ratio and be overvalued. Hence, it is important to understand all aspects before investing.
The stock market is inherently volatile: Since the P/E ratio depends on the market price of the share, when external factors turn markets volatile, the stock price becomes volatile too. This makes it difficult to get a steady P/E ratio. Hence, avoid using the P/E ratio to assess the demand for a stock during highly volatile market periods.
Dig deeper: A high P/E ratio can be a good indicator of a company with good growth prospects. However, it is not enough to look at the P/E ratio alone. Ensure that you analyse the financials & fundamentals of the company and its competition to determine its growth prospects.
Maintaining its position in the industry: Generally, higher P/E stocks have the pressure to maintain its leadership position in the industry and they face the threat of new entrants, competition from peers, maintaining the brand loyalty and reputation. Investors should take all these factors into consideration.
Conclusion:
While looking for a stock with a higher P/E ratio than its peers can be a good place to start, investors must try their best to avoid the infamous P/E trap. While the P/E ratio can help you get a good idea of the demand for a particular stock in the market, ensure that you keep the above-mentioned points in mind before taking the plunge.
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