What is the right P/E for a stock?

This is a very interesting question. Every investor keeps asking this question. However, as happens with other existential questions in life, there is no right answer to this question. In other words, it all depends on your judgment.

An investor may expect good earnings from a stock going forward and buy it at a high P/E. Another investor may not share the same enthusiasm and consider it an expensive stock. The right P/E depends on what you consider the earning potential of a stock.

Generally, P/E ratios of 12 to 20 are considered normal across companies with neutral to positive outlooks. Legendary Investment Guru Benjamin Graham said that 20 P/E the maximum one should pay for an investment purchase of a common stock. Many times you see that the P/E ratio of certain companies, sectors or a whole market traverses to dangerous levels. Generally, it happens when emotions run high and people forget the basics of stock valuation. In 2000-2001, we saw how technology companies were trading at 60-90 times their current earnings. These ratios are not sustainable in the long term. Event the best companies cannot deliver the growth required to justify the P/E ratios of 60-90 on consistent basis. Many times investors get into a frenzy of buying stocks that everybody else is buying and pay very dearly for this mistake.

If the P/E ratio of a sector or a company is higher compared to the historical average P/E, you have a reason to investigate the reason for this abnormal behavior. If there is a valid reason for such a high P/E, you may consider buying it otherwise stay away from it. Generally, whenever a sector or a whole market goes beyond its historical average P/E, there is a correction, unless there is a fundamental change in the business scenario. Therefore, when you see a stock with high P/E, you must ask how justified earning expectations are from the stock.

Different industries have different P/E ranges based on their earning potential. You will see many metal companies operating at low P/E ratios. That’s because they have low margins and there’s very little for them to differentiate from their competitors. Hence, their ability to command a price premium from their customers is limited. On the other hand, technology companies generally sell at a higher P/E multiple as people have high expectations from them. These companies in general are able to grow at a faster clip too. Hence, variations in the P/E ranges of different industries are acceptable. One pertinent point here is that high P/E ratio makes a company risky too as its high stock price is based on future expectations rather than its past or current earnings. This is generally true of new technology companies. Many value investors stay away from technology companies as they cant put a price on the value of the technology. Frankly, it’s not an easy task to predict evaluate the business value of a technology with certainty, as tech space keeps changing very quickly. You should, however, not treat all technology companies equally. A few of them like Microsoft, Google, Oracle, etc have developed product portfolios and brand equity that helps them ensure that they have a predictable earning stream. If you can understand how a company is making money and how sustainable its earnings are, you can put a value to its stock. Otherwise, you will be indulging in speculation by buying a stock that you don’t understand.

Cyclical industries generally have varying average P/E ranges based on the phase of the industry. Steel industry goes through a cycle or 8-10 years during which demand in the market goes from low to high to low again. The industry also goes through a complete cycle of high capacity utilization, high capacity creation and low capacity utilization, which leads to further variations in the financials of the companies.

You should also note the limitations of using P/E ratio. Earnings are not cash flow. Many a times, company management try to fool the investors by manipulating earnings in a particular year, as it’s an accounting measure. While you must have a look at the P/E of a stock before making your investment decision, P/E ratio in isolation is not an indicator of the worth of a stock. You must look at the past earnings, changes in the accounting policy and free cash flow of the company to counter this problem.


On its own, P/E ratio is meaningless. It’s an indicator of the value of a stock. It’s not the cause of the value of the stock. It’s an effect. Understand the difference. There must be a fundamental reason why a stock is priced the way it is. Your analysis should help you find this reason. You will also see that some of the companies in a sector trade at a relatively higher P/E than others. There must be a reason for this difference in the companies. May be the companies with a higher P/E are more efficient. Or they have a strong brand that ensures that customers keep flocking to them. If a company is going to launch a potential market-winning product, there is a reason for a high P/E. If a stock has got a low P/E, this is not a reason enough for you to invest in the stock. If there is a regulatory change that’s going to make life difficult for a company, there is a reason for a low P/E. Therefore; you must try to understand the underlying reason for a stock’s P/E variation from the norm. If you are able to get to the root of the variation, you will be in a position to make your own decision on the stock.

Value Investing: How to find a value stock

Whenever somebody talks about ‘Growth Stocks’, he or she also talks about ‘ Value Stocks’ in the same breath as both these types of stocks are considered two primary types of investment worthy stocks. In my last post, I talked about ‘Growth Stocks’. It’s but natural that this post is about Value Stocks and the philosophy behind picking a value stock i.e. Value Investing.

My whole blog is primarily about value investing because this is perhaps the most robust and least risky way of investing in stock marekt. Legendary investment guru Benjamin Graham and his equally legendary disciple Warren Buffett have made ‘Value Investing’ very popular amongst investors. Practising value investing requires some amount of effort and patience from an investor. Which is why though value investing is a much talked about term, it’s not really widely practiced despite its obvious advantages.

The concept of value investing revolves around investing in stocks that are trading at a price levels lower than their ‘intrinsic value’ or their real worth. The fundamental thing to remember in value investing is that when you are buying a stock of a company, you are essentially investing in the business of the company. You should buy a stock only if you believe that the business behind the stock will be able to give you good returns on your investment. Before investing in its stock, you should assess the business fundamentals, earning stability and growth, financial structure, dividend record and the management quality of the company. A value investors pays special attention to the principle of margin of safety before investing in a stock. A company can be running a great business, but if its stock is priced at a higher level than its intrinsic value, it’s not worth investing in it. Similarly, a company might be in under distress and may have lost the confidence of investors for a temporary period; but it could be a great buy if the intrinsic value of the stock is much higher compared to the current stock price after taking into account the risk factors.

For a full understanding of how you should go about selecting a value stock, you can read the series of posts on ‘How to Select a Stock for Investing’ on my blog as given below:

How to Select a Stock - Part I- Understanding a Business
How to Select a Stock - Part II- Success Levers
How to Select a Stock- Part III- Earning Record
How to Select a Stock- Part IV- Financial Stability
How to select a stock- Part V- Retained Earnings and Dividend Income
How to Select a Stock- Part VI- Management Quality
How to select a stock- Part VII- Finding the right price of a stock

A value investor doesn’t pay attention to trends in the stock market. There are various reasons why a stock price moves in the stock market in the short term. However, in the long run, it is the fundamentals of the company that drive the stock price. If you have done your analysis thoroughly following the value investing philosophy and you are a long-term investor, the chances of your investment going awry are almost zero.

How to find a Growth Stock- what makes a stock a Growth Stock

A growth stock, by definition, is a stock that has a growth rate much superior to average growth rate of the stock market. Ideally, the earning growth demonstrated by a growth stock should be growing at far higher rate than an average stock in the stock market. When people talk about growth stocks, they invariably talk about value stocks in the same breath. The key difference is that much of the valuation of a growth stock depends on its future performance and the valuation of a value stock depends primarily on its past performance.

You should be very clear about two things. First, what growth a growth stock is, and second, whether what people are claiming as a growth stock is really a growth stock.

Let’s try to first understand what a real growth stock is. A real growth stock is a stock that has been showing an above average growth rate in its earning and sales over the last 4-5 years consistently without compromising on its business fundamentals and financial future. If a company has been funding its growth through unsafe loans, which will cripple its earning capacity in near future, it can’t be called a growth stock. You should also pay attention to growth in per share earning on diluted basis ( earning per share after taking into account preferential shares, warrants, stock options, etc). The earnings overall might have grown, but have earnings per share grown? If not, then, the stock can’t be called a growth stock. After all, you will pay premium for the expected growth of earning per share in future. If the company management has not grown per share earning in the past, you can’t just trust it to do so in future.

A growth stock should never be considered for its growth alone. Consistent growth in earnings could be a reason why you want to evaluate it for investment purpose. However, make sure that you analyze the stock thoroughly the way you will analyze any other stock. You can be a little liberal in assessing a growth stock in a few parameters like Price to Earning Ratio or Dividend Payment. However, there should not be any let up in the assessment of the financial stability and management quality.

In a growth stock, the earning growth should more than make up for the liberal PE ratio or lower dividend payment. While evaluating a growth stock, be especially careful to take into account a few other factors like:

· Net Current Asset Value in order to determine the financial viability of the firm in question
· Current Asset Value in order to determine short-term financial viability of the firm
· Debt to equity ratio
· Quality of the Current Assets.
· Performance and the credibility of the management
· Change of management in recent years and its impact

How should you find whether a so-called growth stock is really a growth stock or not? If you browse through recommendations of many investment analysts in the current environment, you will find that many of them claim that they are following growth-investing philosophy while recommending stocks. Most of them have favorite stocks that have shown promise in recent years. These stocks would have grown their sales and earnings at exponential rates in the last 2-3 years. Based on this sudden spurt in their performance in the recent past, analysts start recommending these stocks as growth stocks. As is expected, many lay investors blindly jump in to investing in these so called ‘growth stocks’ without even understanding the businesses behind these stocks. These stocks are not growth stocks; instead they are fashion stocks. Every once in a while stock markets come up with their favorite fashion stocks which are bought and sold blindly without any consideration to their underlying business value. A little peek into the history should keep us sane as most often these misinformed investment result in disastrous returns and heartbreaks. Before investing in any stock, you need to analyze it thoroughly to be confident of its value as explained in this post earlier.

How to select a stock- Part VII- Finding the right price of a stock

In this post, we will learn about how to find the right price for a stock. Many people confuse good companies with a good stock. If they like a company’s business model, they purchase its stock without any consideration of the price it is trading at. What matters more in investment is that you have bought a stock at the right price. If you have bought stocks of a great company at a very high price level, it may not turn out to be a great investment. On the contrary, if you have bought stocks of a good company at a good price level (cheap), you may get good return on your investment. It’s important to buy cheap.

A stock price is supposedly an indicator of net present value of future earnings for the stock on per share basis. This is also called the intrinsic value of a stock. However, the problem with this concept is that one needs to predict the future to be able to arrive at the right stock price. Millions of people have tried predicting future in the past, but rarely have we seen anybody doing so accurately. This very concept leads to a lot of investing mistakes by millions of people. A lot of analysts get into the game of predicting future earnings through various esoteric mathematical formulae. Nobody gets it right!

A good approach for stock selection could be following what legendary Investment Guru Benjamin Graham advised- follow the principles of ‘margin of safety’ and ‘diversification’.

The margin of safety concept says what you are buying should be worth more than what you are paying by a wide margin. Such a simple thing, but it’s really difficult to act on it considering the problem in assessing the value of a stock. Graham says you shouldn’t get into the business of predicting the future; instead, use the past performance to assess the ability of the company to keep producing decent earnings in future. Hence, if the company has a current earning of about 12% of the stock price (i.e. a PE ratio of 8), and meets all our criteria of selection as mentioned in my previous posts, and risk free return (of a 10-year government bond) is 6%, you have a good margin of safety in the stock. There is no general formula for all industries. However, in most of the cases, the PE ratio should not go beyond 15. The higher the PE ratio, the more future growth dependent your return on the stock becomes. Never buy a stock if you believe it is fully priced even if it is of the best performing company.

Diversification is linked with the concept of margin of safety. Let me explain. If you are playing dart, and you are good at it; what are your chances of hitting bulls eye once if you have only once dart? What if you have ten darts? Of course, you will have much better chances of hitting Bull’s Eye at least once if you have ten darts. Do you understand the difference? If you have margin of safety in your favor, your chances of making good returns or at least not incurring loss in a portfolio of diversified stocks becomes pretty high. However, there is a caution here. Diversification will work to your favor if you have diversified in stocks with good margin of safety. It will hurt you badly if you have bought all losers. Diversification in overpriced stocks will ensure that you most likely incur loss on your investment. So, be careful. Don’t buy costly stocks. Always maintain a diversified portfolio of good stocks bought with a margin of safety.

With this, the series on ‘how to select stocks for investing’ ends. I hope I have been able to give you a few basic guidelines on how to go about picking stocks for investment. I must add that these are indicative guidelines and by no means exhaustive. You will do well if you use these guidelines along with your own research and experience backed by some sound reasoning.