Price to Earnings ratio loses value in rising market

"Price is what you pay. Value is what you get. The dumbest reason in the world to buy a stock is because it's going up," says investment guru Warren Buffet.

Trashing conventional principles of investing, Indian investors are on a shopping spree, buying all that is going up, without considering the price or the value of stocks. Price to earnings (PE) ratio, as a concept, appears to have lost its relevance for the time being as investors are busy trying to guess the next level that benchmark indices are likely to touch in the near term.

The 30-share Sensex on Friday soared to a new high of 16,616.84 as investors are counting on stronger foreign fund flows in the coming days, given India's better resistance to a likely recession in the US compared with other emerging markets.

A study on the trading volumes of topline stocks on BSE reveals that investors are accumulating 'high PE' stocks -- trading in the range of 30-160 times -- in large numbers. PE ratio gives investors an idea as to what the market is willing to pay for the company's earnings.

The higher the PE, the more the market is willing to pay for the company's earnings. PE, as a stock market indicator, helps the investor in deciding whether he should invest in a particular stock or not.

A scrip trading at a PE of 15-18 times is generally regarded as a 'fairly valued' stock across markets, provided the company has decent earning potential. In the Indian context, with the Sensex trading at a PE of 22 times, stocks trading in the range of 18-20 times are not seen as overvalued.

"PE can be a bit more higher in the case of high-growth sectors like realty and telecom," said a fund manager. Conversely, a low PE may indicate low investor confidence in the stock. It could also mean that the scrip is a 'sleeping multi-bagger' that the market has overlooked. Known as value stocks, many investors made their fortunes spotting such stocks before the rest of the market.

So, considering the current trend, how relevant is PE?

Generally, in a uptrend, investors with a higher risk profile (those investors who are not investing for the long term) invest blindly without considering much about the fundamentals or value proposition of stocks. This is a dangerous trend, as stocks appreciating on 'sector-goodies" plummet once sentiments change, says experts.

"PE, as an easy analytical ratio, is still relevant for investing in stocks. But in a surging market, people generally don't buy stocks by considering the PE ratio," says Indiabulls Securities CEO Divyesh Shah.

There is no simple method to spot the right PE for a stock. If an investor is willing to pay more for a particular company's stock, he believes the company has good long-term prospects over and above its current position. "Though PEs don't tell you the underlying story, it will give you an idea as to how the stock is valued.

High-demand stocks, with low free-float, will also have high PEs. Therefore, along with the PE, investors should also consider the long-term growth prospects of the company they are investing in," sums up ASK Wealth Advisors CEO Rajesh Saluja.