Photo: iStockphoto
Photo: iStockphoto

PE ratio can help assess value of your portfolio

The PE ratio by itself says little, you have to associate it with an industry, a portfolio and its historical trend to arrive at a relevant conclusion

After the recent highs, as markets start to correct once again, the conversations around valuation have resurfaced. But before you decide to change your allocation based on whether the market is expensive or not, understand what valuation you need to be concerned about. Looking at price-earnings (PE) ratio can help assess valuation.

Historical versus forward PE

Simply put, PE ratio takes the current market price of a stock or what you pay to buy it and divides it by the earnings per share (EPS) or what you earn for each share. It represents how much you are willing to pay for the annual earnings of the company. A PE of say 20 times signifies that for every Re1 of earnings, you are willing to pay Rs20. The price paid, however, is not reflective of the absolute earnings, rather it indicates your expectation on annual earnings growth. A high PE reflects expectations of high earnings growth over the next year and vice-versa. 

A trailing or historical PE is calculated using the previous 12 months’ earnings and shows what is already achieved.

A forward PE is calculated on the basis of estimated one-year earnings for the year ahead. This can be done based on your own estimates of how the company profits will come through or on analyst expectations. A forward PE is more dynamic as any corporate announcement or external factor can impact future earnings estimates and alter it. Unlike trailing PE, this number is dependent on individual analyst biases. But it’s useful to consider both simultaneously for stock selection. 

Need to look at portfolio PE

The portfolio PE ratio is the weighted average PE of all individual stocks put together. A market index is also a portfolio of stocks and its PE is the index price divided by aggregate earnings of individual stocks. 

The PE of two portfolios can be different depending on the type of stocks they hold. For example, if you have invested in a large-cap fund, the PE can look lower compared to a small- and mid-cap fund. So never compare dissimilar portfolios. 

Similarly, if you have a portfolio with a growth-oriented strategy, it is likely that its PE ratio is much higher than for the one with a value-oriented strategy. 

The PE ratio by itself says little, you have to associate it with an industry, a portfolio and its historical trend to arrive at a relevant conclusion.

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