To invest in stocks you need to understand a few terminologies about valuation. How do you figure out if the stock price of a company is overvalued or undervalued? There are many ways to do this but the most often quoted ratio is the P/E ratio, or the Price to Earnings Ratio.

But before you have that, you should understand EPS – or Earnings Per Share. Every company releases quarterly results in which it announces its profits, total equity capital and basic and diluted Earning Per Share. This means Net Profit divided by total number of shares. The idea here is – if a company has 10,000 shares in total, and the company makes 500,000 in profit (in a quarter), the EPS for that quarter is Rs. 50. If you “annualise” that EPS – meaning prorate it over a year, the EPS would be Rs. 200.

But of course the company may go through quarterly earnings changes, so you don’t just multiple quarterly earnings by four. What you do is to take the LAST FOUR QUARTERS EPS, and add them up to get the “trailing four quarter EPS”. This is the Trailing EPS.

Aside: How you get these figures is to go to http://www.nseindia.com and look for the last four quarter results. For instance this is the BHEL page, which has links to the last eight to twelve quarters of results. You can add them up manually, or visit sites such as moneycontrol.com or myiris.com to get a pre-added set.

Now, the past is the past. It is not the future, right? So some analysts will check the company and release estimates of how much the EPS will be for the next four quarters. This is called the “forward EPS“.

P/E Ratio: How does the EPS help you? It does not. It’s not reflective of anything in itself. You must take the stock price and divide it by the EPS, to get the P/E ratio. The P/E ratio, for BHEL for example is about 26 for the trailing four quarter EPS. If you consider that it’s last quarter earnings will be the same over the next four quarters, the forward EPS is 108, and the forward P/E is about 22. (at todays price of 2350)

The P/E ratio (also called the “Earnings Multiple”) needs to be compared in the same sector that a company is in. P/E of a sector is usually at similar levels – for instance, tech companies have P/E of around 30-35, PSU banks 5-10, Private banks 22-25 and so on. BHEL might sound high at 26 – but other heavy engineering companies like Praj Industries have an even higher P/E.

Other factors can influence P/E – visibility of earnings (longer the better), order book, brand name etc. What people generally say is that the P/E should reflect the percentage growth in earnings of a company. That means if BHEL gets a P/E of 26, it should grow at 26% (net profits) – now the most recent quarter has shown much more than that – 45%+ so the company is still undervalued by that measure. Forward growth looks robust, with an order book of more than 30,000 cr. and going forward, I would expect that even if the P/E is lowered (because of a correction), BHEL’s earnings growth itself would cover it and the stock price will sustain itself.

There’s one more thing called “diluted EPS”. When a company issues stock options, or raises capital using convertible debentures, the number of shares issued will increase when the stock options are exercised or when the debentures are converted. Eventually this means an increase in the number of shares, that is sure to happen, it just hasn’t happened yet. So the company needs to release the “diluted EPS” meaning the total known number of shares that must be used for the EPS calculation. Always use diluted EPS when making any P/E comparisons.

Note here that forward P/E calculations can be based on unknown numbers – every analyst will have his or her own set of numbers. Always take an average of multiple numbers when you analyse estimates.

>Thanks for the post. I was looking to understand how P/E works. I’m a rookie investor trying to understand how to invest in the markets. Your post has helped answer some of my queries. Thanks again 🙂

>Hi Deepak.

Great post as always.

How relevant is PEG in figuring value of a company?While calculating PEG is it the previous EPS growth or forward EPS growth that is to be considered?

I tried PEG calculations for many of the Sensex companies and found that a lot of them like Bharti, TCS and even BHEL are having PEG less than 1.Is it correct to say that these companies are undervalued?

Another small question: In view of yesterdays correction do you think Hindalco is attractive at current levels? I hold them at 172 and i’m thinking of lowering my holding cost.

Thanks in advance

Vikram

>Vikram, thanks! PEG is important because universally, PEG (the ratio of P/E to EPS growth annualised, for those who don’t know what PEG is) should move towards 1.

So does that mean that a PEG of less than one (meaning P/E is less than earnings growth) is attractive? In theory yes, but in practice this is not necessarily true. Reliance for instance has grown at 30% plus levels for a long time now, and it gets a P/E of around 20 – in fact, for the last three years, the P/E has been around 15.

Having a PEG of more than 1 makes a company unattractive, but less than 1 does not make it necessarily attractive. Other factors may apply – like visibility of earnings, hidden investments, cash flow position, external industry trends, interest rates etc.

TCS has a very high P/E already – compare that to the index P/E of 20 or so. So if this company grows at 30% over five years it will still be a good company, but the P/E will probably come down to below 30 then…that’s lesser than today.

Bharti has also got a very high P/E and you must note that the Walmart deal is now in trouble with the govt., so that may affect sentiment (not earnings, sentiment only)

I like BHEL – it has a very visible order book, and regardless of bull or bear markets its the kind of company I would like to hold.

Hindalco – well, the deal they just did looks EXTREMELY expensive. I need to analyse that – but I would say analyse the purchase yourself and see if they are paying too much, before you take a position.

NOte that forward EPS growth is what should be considered for PEG calculations – hindsight is 20/20, but tomorrow is what matters 🙂

>Hi Deepak,

Thanks for the Article on EPS and P/E.Based on your inputs I tried calculating the EPS for NTPC. I took the Fourth, First, Second and Third quarter EPS from the http://www.nseindia.com/marketinfo/companyinfo/eod/corp_res.jsp?symbol=NTPC site. Total EPS comes to 8.21 and based on this the P/E comes to 17.69. However the EPS on moneycontrol is given as 6.67 and the P?E comes to 21.78. Which of the teo figure is correct, and if at all where did I go wrong.

>Ashish, you are right, and moneycontrol is wrong (or outdated). This is a good reason why you should not take web sites at face value. See – the valuation of NTPC changes when you see the real picture…

>Deepak

Any comments of the IDEA Cellular IPO?

>Hi Deepak,

I have seen with my experience PEG working very well for fast growing companies.

If you take Matrix labs, Mercator lines or more recently, ICSA, Geodesic etc all these companies in growth period had a very less PEG and there were great returns in these if someone would have held these for 1-2 years.

from DeepakR

>What is the best site to get a reliable PEG for Indian Stocks ? I recommend using PEG but at the same time make sure you are not overpaying for Sales (P/S) when screening for stocks…..

Ram

>To get the best out of PEG Ratio, it may be prudent to follow investment guru Peter Lynch’s advice – first, find the companies whose long term prospects look good and have good management quality and then check whether their share price is under-valued using the PEG Ratio.

Ram

>Hmm – there are very few sites that give you PEGs, but you can derive it easier using certain sites like http://www.stockhive.com.

I like the idea of showing PEG as an indicator – using perhaps average of last four quarter earnings growth?

>Read an article that for different sectors the avg PE ratio may be different and hence you can’t just base your decisions on PE ratio..IS this is true,how do I know what is the avg PE ratio for a particular sector and what is the expected PE ratio for a sector?

>Anon: You’re right, typical P/E ratios for sectors is what matters, like i’ve mentioned in the article.

Unfortunately there aren’t any sites I know of that give sector P/Es. Dalal Street Magazine (and others like Capital Market etc.) have this data in the printed form.

P/E of a sector is usually around the sectoral earnings growth rate. Steel grows at 5-10% so sector P/E is around that. Software on the other hand is a 30%+ grower, so the P/Es tend to be more than 30.

>Hi Deepak,

Very good piece, this. I have always invested on the basis of what I hear in the media and other intangilbles such as ‘instinct’. I should consider myself quite lucky as I’m yet to feel sorry for any of my investment decisions. Now I want to add some rational and objective ‘knowledge’ to my monney affairs and would like to begin by understanding how stocks work.

I would really appreciate it you could point me to some resources on the net where I can learn about the basics of stock analysis, without the jargon right at the beginning.

Just to reinforce – this is good work. Many thanks and congratulations on the birth of your son!

Cheers,

Raj

>well I knew about P/E but I just wanted to thank deepak for telling me about stockhive.com …its a wonderful site .. thanks again deepak … I was looking for such kind of site for a long time..

>I have been looking at a few Internet sites that provide market data, but none of them seem to provide earnings, earnings per share, or earnings estimates. Can you point me to a place where these can be obtained?

>Rediff, India bulls, moneycentral etc do not seem to have more than 5 years of EPS data.

A lot of companies have more data on their anuual reports but the below companies don’t have that either.

aban

abgship

aloktext

avayagcl

bel

chamblfert

drreddy

enginersin

federalbnk

gitanjali

hindzinc

infosystch

jbfind

litl

maruti

mic

mtnl

nalco

polaris

redington

relcapital

sail

sasken

srf

stcindia

ster

suzlon

syndibank

uttamstl

zicom

zylog

Do you know of any sites which might have around 10 years of EPS data?

>HELLOW SHREE DEEPAK SHENOY JI , I AM FROM SURAT, I WANT TO KNOW WHICH PE/EPS GOOD FOR STOCK BUY, MEANS THAT IF PE>EPS IS OR EPS>PE.

IF PE<10 & EPS>10, I HAVE NOT MORE KNOLADGE ABOUT IT PLS GIUDE ME ABOUAT MY CONFUSON

.

>Go to MSN money to get EPS of various companies