I here briefly intend to discuss the significance of P/E (Price Earning) ratio.
Traditionally PE ratio means the division of the Profits (earning) of a company by its price. If you expect the rate of return of 10% then a stock with PE ratio of <10 should be a good buy.
Things that can alter the PE ratio calculation:
- Sunshine Industry:
People do not mind paying high premium to Industries like IT, Pharma, logistics which have high growth potential. Next year the revenue might be much higher and so will be the return prospectus.
- Change in Management.
The balance sheets of privatized companies, merged/acquired companies usually take some time before it gets reflected as profits.
- Other income.
Beware of the concept of other income. Which usually arises from one time sale of land/ machinery/assets or financial jugglery. It is a one time income and is no reflection of the strength of the company.
A good promoter and management often command a premium because of the underlying track record and trust.
- Policy changes
Often changes in global scenario lead to opening on newer opportunities and companies can expect a boom.
- Interest Rates/ Taxation:
An interest rate of 6% means a PE of 16 is attractive, but a interest rate of 7% means PE has to be at most 14.