Expert: Paul Henneman - 10/31/2006

Question
Sir i am an mba student in india i invest in indian stock market but i just read a question about barclays p/e being 10 . i read some material and the formula for P/E is market price divided by earning per share. The formula is fine its easy i am having difficult in the analytical part. Lets assume in india and average P/E of FMCG company is 30 . Well now if a P/E of an FMCG company is 40 they say its high and it has future growth prospects in its earning so therefore it can boom and if an FMCG company having a P/E of 20 is low and its future earning might not be that good. Well my confusion is if denominator is high P/E will be low but that means earnings is going down and its a bad sign for a company and if the EARNINGS GO DOWN then the P/E will be high I MEAN EARNINGS ARE DOWN AND PEOPLE SAY HIGH P/E INVEST INVEST .. Pretty confused sir i hope u could understand my questions . Thanks vishal . hope you suceed in clearing my queries.

Answer
Thank you for your question!
    Unfortunately this is a large issue, and there is not a clear answer to it. But I hope that I can give you some basics on how to begin thinking about P/E ratio.
    The analytical part that you mention is the problem. There are two ways to look at P/E ratio.
     Some investors find a high P/E ratio more favorable. A high ratio essentially means that investors are willing to pay more for the stock. Perhaps earnings growth is extremely good as well, and would help support the high p/e ratio. My suggestion would be that if you are a risk taker, and tend more towards momentum type investing, this would be the way to use p/e ratio.
    Other investors seek out low p/e ratios. A low p/e ratio could be a sign that a stock is undervalued, and at a level where it is a good buy. You should always look at other things as well, to check if the company simply is just not doing well and earnings are shrinking. However, if the company is sound, with decent prospects for the future, these types of investors seek out lower p/e ratios.
    One thing I always recommend is that p/e ratio should be used in combination with sector averages and competitors ratios. For example, it is far more important on how a particular company's ratio compares with competitors and the sector group overall. A 'good' or 'bad' p/e ratio number may be very different depending upon the sector, and may change with time for the same sector. If the market is strong, typically average p/e ratios are higher. The investor has no way of knowing what is an 'average' p/e ratio unless you check competitor companies and the overall sector average.
   In summary, the answer to your question really depends upon what type of investor you are. You should also use competitor company ratios, and the average ratio of the sector to compare what you are interested in to see if it is truly a high or low p/e ratio. Finally, additional data points should be looked at. What may appear at first sight to be a high p/e ratio may actually not be if the company is growing quickly enough, and the reverse may apply to what appears to be a low ratio.

I hope this helps! Please do not hesitate to follow up with me if I can be of any further service,

Sincerely,
Paul Henneman
President
ValuEngine Inc
www.ValuEngine.com